We divided our sample into countries, actually, episodes of countries, that had fixed exchange rates, and episodes where countries had flexible exchange rates. [slide 8] And here the difference is even more striking. It appears that exchange rate regime is very, very critical in determining the effectiveness of fiscal policy. The blue line over there shows countries with fixed exchange rates, and the red line countries with flexible exchange rates. We see that while the multiplier is rather large in countries with fixed exchange rates (actually exceeding 1, about 1.5 if I recall correctly, I can’t see it there) and in contrast, in countries with flexible exchange rates, the effect is almost zero. So fiscal policy appears to be very ineffective in countries with flexible exchange rates. – Ethan Ilzetzki
Actually, it was not immediately obvious why Vince was so excited about this LSE hotshot’s research. And then this morning I saw twinned stories on Japan1 and China.2 Well, the fog began to lift.
Doom is just finishing up the Ilzetzki presentation at the beginning of the second part of the VI Charlie transcript, and I just returned to slide #8 on his slide deck and cranked up the magnification. Indeed, it looks like if a country loses the peg on its money (as Japan is threatened with these days) your basic fiscal stimulus seems to turn into an exercise in pushing on a string. That is, the force of your spending just dissipates into the forex markets. No wonder Wen is guarding his peg so jealously.
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Notes and References
[1]: "Yen surge a ‘great concern’, says Japan bank chief", AFP, November 30, 2009.
The surging yen, which hovered around 86 to the greenback in Tokyo on Monday, could set back a recovery from Japan’s worst post-war recession because it makes the country’s exports less competitive.
…Japan is emerging from recession, in part due to stimulus measures and as exports have picked up, but falling consumer prices have threatened to throw the country into a deflationary cycle.
[2]: "Wen Says Yuan Pressure Unfair; Europe’s Lobbying Fails", Bloomberg, November 30, 2009.
“Some countries are now calling for yuan appreciation while imposing trade protectionism on China, which is unfair and actually limits China’s development,” Wen said at a briefing in the Chinese city of Nanjing today. In the financial crisis, “a stable yuan is helpful to the development of the Chinese economy and the world’s economic recovery,” he added.
Uh.. I think you mean Monetary Stimulus is pushing on a string, right?
Chuck -
I thought I meant what I said, but it is more than possible that I don’t have a firm grip on the difference between the two
Please elaborate (Igor’s not the only one in The Castle that’s “confused”) and if you can give us a start to a sensible unraveling of this stuff Doom will be delighted to consider posting it.
Well…
Fiscal Policy in the US is controlled by the US Government… Revenues come from collection of taxes, and the expenditures come from various legislation. Basically, Fiscal stimulus comes from Congress or the US Government.
Monetary Policy in the US is controlled by the banking cartel known as the Federal Reserve system. Monetary stimulus is a function of interest rates (overnight lending, interbank, etc). They can stimulate the economy be charging a lower percentage rate to their member banks and they should (in turn) lower the interest rates to their consumers (companies and people).
The term “Pushing on a String” describes what happens in monetary stimulus where the FED lowers rates, but that fails to ignite borrowing by consumers or companies. Indeed, the FED is pushing money into the economy, but instead of it being taken up, the string remains slack, and banks are unable to lend. This can have 2 possible causes: either banks do not see sufficient lending opportunities because all risks are bad, or consumers do not see sufficient borrowing opportunities because all risks are bad. In either case, what happened in Japan was pushing on a string because although the rates were held low for an extended period of time, companies did not use this to invest in their own economies and therefore fuel demand which should have fueled some inflation. Instead, this created what was called the “carry-trade”, where basically people would borrow in Japan and export that borrowing elsewhere (invest somewhere else using Japan’s ultra-low rates). Some fear we are facing our own potential carry-trade here in the US. This would grow our monetary base without creating any inflation.
Chuck Ponzi
As a second note… I went back through and re-read the section preceding and following your above quotes, and I have to say that either he’s talking on an entirely different plane than I can think, or he’s making a spurious jump from fiscal multipliers to exchange rate regimes. I just don’t get the relationship and how that interrelates on a macro level the way that he says it does. To me, it seems quite contrived.
Perhaps if I read it another 10 times I’ll get it.
Chuck -
That’s good stuff …
I hope to take your comments above the fold in the next day or two as a Doom guest post. Meanwhile, I see that Vince was starting a discussion following Ethan’s presentation. Maybe there will be some light generated by the pros rubbing against each other
Chuck (#4) -
I don’t think the link between exchange rate regimes and fiscal multipliers is so much a spurious link as a key assertion supposedly coming out of his group’s study of the multi-country data they’ve been collecting. If the assertion were to hold up it might turn into a flaming sword with which the assembled worthies at the AEI could influence policy-making left and right.
That’s why close scrutiny of this stuff is so critical. Things could get dangerous pretty fast if Ethan’s conclusions get into the wild unexamined.