Currency Values and Inflation: Response to Mike P.

by robekulick

So this comment comes all the way from Canada and its a good one so I’ll reprint it here:

“Hey Robe, one question I had for you – for the countries in which currencies are overvalued (US, Canada, Switzerland, Australia etc), and they want to devalue to encourage exports (and ostensibly, to decrease the relative value of their outstanding debt, as well as increase available public funding without levying direct tax), why can’t they just issue money? Obviously they don’t want to go nuts, and incite rampant inflation and undermine confidence in the currency, but there’s an inflation rate anyways, which means they must create new money every year – couldn’t they just devalue slightly ahead of the curve?”

One first thing to note is that in traditional rational-expectations based macroeconomic models where countries have floating exchange rates as opposed to fixed exchange rates, it is generally the case that there is no such thing as an “overvaluation”/”undervaluation” of a currency in equilibrium. Viewed from this perspective, differences in prices of a currency are simply the result of differences in factors like prices and wages between countries. To the extent there are distortions, those will result in arbitrage opportunities for currency traders and any currencies will resume trade at their appropriate levels. Now of course, there are many models that very these assumptions because in the real world there are distortions that prevent markets from working perfectly. However, because most economists believe the market mechanism is powerful, direct intervention to adjust currency rates is somewhat frowned upon under normal circumstances.

Then there are other factors to consider. For instance, I’m not sure that the U.S. currency is overvalued, though there is a case for arguing that the Swiss currency is overvalued. The U.S. is certainly expensive relative to the Yuan (Chinese) but that is because China pegs their currency to the US currency so there is not a floating exchange rate. So as for the differential between the Chinese and US currency, that is somewhat fixed regardless of what the US does. Furthermore, say the US dramatically devalued its currency in a way that the Chinese are not willing to do. As major holders of US government debt, they would likely start selling their US bonds for fear of inflation eroding the value of their investment and no one wants to see what will happen if the Chinese (and other Asian countries) start unloading their US bonds en masse.

In a country like Switzerland, if the currency truly is overvalued, I think that political considerations are the most likely culprit. As everyone knows, banking is the major industry of Switzerland and thus I’m sure it wields a lot of muscle in politics. When currencies fall in value, the value of bonds goes down because (most) bonds work by simply giving the holder a fixed monthly payment known as a the coupon. Since banks are generally large holders of bonds, it makes sense the Swiss would discourage their currency from falling in value.

Now that isn’t to say that there aren’t a lot of people in the US who would like to see the Fed increase the money supply (increasingly I’m coming to agree with this position too). But the main rationale for this is to increase aggregate demand. In other words, the idea is that to get people to spend their cash rather than horde it as happens in recessions, inflation causes the cost of hoarding money to increase and causes people to increase consumption. To the extent our current economic woes are caused by low aggregate demand, this could help with economic growth. I’ve actually wanted to blog about the whole inflation debate for awhile and its a big subject so I won’t go into it too much here so I can discuss in at length in some future posts. But what’s really fascinating is that the discussion can’t really be summarized in terms of a dichotomy between conservative and liberal economists like these issues usually are.

For instance, the conservative Scott Sumner, and the liberal Brad Delong have both been advocating for an increase in the money supply. The rule proposed by the conservative economist Greg Mankiw here:

would almost certainly lead to short term inflation. Meanwhile conservative economists like John Taylor and Anna Schwartz have vigorously opposed expanding the money supply. As for Paul Krugman, he seems pretty wedded to the traditional Keynesian idea that when interest rates are near zero, the money supply can no longer be effectively expanded, so I think he is probably not a proponent of increasing the money supply, but I don’t know this for sure. If anyone sees anything by him explicitly discussing the issue, please send it my way. In general Krugman is a much bigger advocate of fiscal stimulus. I’ll discuss the ins and outs of all of this soon.

As I said, I think increasing the supply of money would be a good idea and this would likely weaken the dollar, but the strong dollar in and of itself is not the problem in the US. One more point on the issue, even if currency markets are in disequilibrium,  printing money is not an exact science. Thus, part of the hesitance to adjust the currency rate is that some economists believe strongly that it can be rather difficult to stop inflation once it gets going…and stopping it usually is very unpleasant and induces a recession. So that’s my best answer to your question. Hope it makes sense to you!