Transcript Post-Keynesian monetary theory and policy in an open economy

Post-Keynesian
monetary theory
and policy in an
open economy
Marc Lavoie
My interpretation of PK theory based on…
• Two papers that I wrote in the JPKE (2000, 2002-3), about
forward exchange markets, based on the so-called cambist
approach, developed in the 1970s by French practioners and
scholars, one of which was my teacher in 1976-77.
• A book chapter that I wrote in 2001 about the sterilization of
foreign exchange reserves, based on the ideas developed by
the same practioners (the Banque de France view), also found
in my 1992 book.
• My understanding of the clearing and settlement process in
Canada, as expressed by the practioners at the Bank of Canada
who developed this system.
• My collaboration with the late Wynne Godley, in particular three
papers that we wrote on stock-flow consistent two- or threecountry models, which reinforced my convictions about the
validity of the PK monetary theory in an open economy
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Outline
• Forward exchange markets and covered
interest parity
• The impossible trinity and the Rules of the
Game
• The compensation thesis or endogenous
sterilization
– Historical examples
– Modern examples
• The eurozone in an SFC model
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The interest parity theorem: a rejection
• The neoclassical interest parity theorem comprises two
relations: covered interest parity (CIP) and uncovered interest
parity (UIP).
• UIP: nominal interest rates (in a riskless environment with
perfect asset substitutability and perfect capital mobility) are
equal to world interest rates plus the expected change in the
exchange rate: R = R* + (se – s)
• CIP: interest rate differentials must be equal to the forward
exchange premium (or discount) relative to the spot exchange
rate: (R – R*) = f – s
• Therefore, UIP and CIP implies that the forward exchange rate
and the expected future spot exchange must be equal: f = se .
• Therefore, if markets have correct expectations on average, the
forward exchange rate should be a good predictor of realized
future spot exchange rates: f = s(+1).
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The forward exchange rate is not a
predictor of future spot rates
• CIP is always observed, provided we note, in the case of capital
controls, that the forward rate paid by a national resident may be
different from that paid by a foreign customer, as euro-markets
will be partly disconnected from the domestic money markets.
• The current spot rate, not the current forward rate, is the best
predictor of future spot rates. Changes in the forward rate are
useless to predict future changes in the spot rate.
• The spot rate exchange rate is related to the contemporaneous,
rather than the lagged, forward exchange rate (Moosa 2004).
• It implies the failure of the so-called unbiased efficiency
hypothesis.
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A reinterpretation of CIP
• The forward exchange rate is not an expectational variable.
• It is the result of a simple arithmetic operation, conducted by
cambists.
• Banks hedge their forward exchange market operations, they do
not arbitrage as such.
• When a customer wishes to purchase dollars forward, banks
cover themselves by borrowing pesos at the rate R and buying
dollars spot, and placing these dollars at the rate R*.
• Banks set the forward rate by adding a simple mark-up (or markdown) to the spot rate, determined by the differential in interest
rates on interbank markets : f = s + (R – R*)
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Implications of the cambist view
• An obvious implication is that covered interest arbitrage has no
impact whatsoever on spot rates or foreign reserves when
exchange rates are fixed.
• Only uncovered forward exchange operations induce inflows or
outflows, and these can be countered by forward exchange
market operations by the central bank.
• Monetary authorities can renew these operations as long as
they have the nerves to face the possibility of losing their foreign
reserves in the future.
• Monetary authorities do have some leeway in setting domestic
interest rates, including real rates, both in a flexible and a fixed
exchange rate regime.
• With fixed exchange rates, the interest rate differential is limited
by the width of the intervention band (4% differentials for 3month T-bills are permitted by 1% spot rate differentials)
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The fixed exchange rate case
• This goes against the usually asserted claim, associated with
the mainstream Mundell-Fleming model, that there is no such
choice in a fixed exchange rate regime.
• Its main assertion is that an economy operating with fixed
exchange rates would lose control of the money supply, and
hence that monetary policy is ineffective (in contrast to the
situation with flexible exchange rates).
• The mainstream claim is that a central bank gaining (losing)
reserves would see its monetary base grow (diminish) and
hence interest rates would drop (rise).
• The money supply here is endogenous, but supply-led.
• (in the PK view the money supply is endogenous, but demandled).
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The impossible trinity – the trilemma
• The Mundell-Fleming model has given rise to the claim of the
impossible trinity. As is well-known in Latin America,
mainstream authors claim that one cannot have together:
– Fixed exchange rates;
– Capital mobility;
– An independent monetary policy (Home-made interest rates
set by the central bank).
• Such a claim relies:
– on the mistaken belief in the relevance of the unbiased
efficiency hypothesis,
– on the confusion between perfect capital mobility and perfect
asset substitutability,
– on the ignorance of the compensation principle,
– and on the inability to distinguish between countries in BOP
deficit and surplus positions.
• .
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The standard view of the impact of a
balance of payment surplus on the
balance sheet of the central bank
Assets
Liabilities
Foreign reserves
Banknotes
Bank deposits (bank
reserves)
Claims on domestic
government (Treasury bills)
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The (neoclassical) rules of the Game
• “In order to maintain a fixed exchange rate, a central
bank must engage in foreign exchange transactions
that prevent it from managing the monetary base so
as to achieve other macroeconomic objectives. If
monetary policy is dedicated to pegging the
exchange rate, it is then unavailable (except on a
highly temporary basis) for application to other
goals.” (McCallum, 1996, pp. 139-140).
• “The Rules of the Game must be such that a balance
of payments deficit should be fully reflected in a
reduction in the supply of money, and a surplus
should be fully reflected in an increased money
supply” (Ethier 1988: 341).
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The rules of the game are not automatic
• Mundell (1961), whose other works are often invoked to
justify the relevance of the rules of the game in textbooks
and the IS/LM/BP model, was himself aware that the
automaticity of the rules of the game relied on a particular
behaviour of the central bank.
• Indeed he lamented over the fact that modern central
banks were following the banking principle instead of the
bullionist principle, and hence adjusting ‘the domestic
supply of notes to accord with the needs of trade’ (1961,
p. 153), which is another way to say that the money
supply was endogenous and that central banks were
concerned with maintaining the targeted interest rates.
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Sterilization in the neoclassical view
Assets
Liabilities
Foreign reserves
Banknotes
Bank deposits (bank
reserves)
Claims on domestic
government (Treasury bills)
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What about sterilization ?
• The effect on the stock of base money of a purchase
of foreign currency can be undone by the sale of
government securities by the central bank. This is
sterilization.
• It is usually argued that sterilization cannot be
pursued for very long or is ineffective.
• For Claassen (1996) [and also McCallum (1996)], ‘in
the context of “perfect capital mobility” ... sterilized
intervention policies are doomed to be ineffective’.
• In our opinion, such statements confuse perfect
capital mobility with perfect asset substitutability.
• They also do not distinguish between countries that
are in a current account deficit situation and losing
reserves, and those that are in a surplus situation
and gaining reserves (say China).
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Another, new, argument against sterilization,
or on the limits of sterilization
• In the context of Latin American countries, Frenkel
(2006, p. 587) writes that sterilization operations:
“consist in the selling of public-sector or central bank
papers with the objective of money absorption. They
imply a financial cost to the treasury or the central
bank, proportional to the difference between the
interest rate of those papers and the interest rate
earned by the central bank’s international reserves”.
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The opportunity cost of sterilization if interest
rates are high in the domestic economy
(the case of a surplus economy)
Assets
Liabilities
Foreign reserves (US
Treasury bills at 1%) ↑
Banknotes (cash)
+
Bank reserves =
Domestic government
securities (at 10%) ↓
High powered money M0
Monetary base
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An answer to this new argument
• It is true that the costs of sterilization could be such
that the central bank would make zero profits or even
operating losses.
• This would reduce to zero the profits that the central
bank usually distributes to the government, thus
reducing the government budget balance.
• If the losses of the central bank are so large that it
becomes technically insolvent, the government would
then need to sell newly-issued securities, that would
be purchased by the central bank, with the proceeds
being invested into the central bank, so as to raise
the own funds of the central bank.
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The compensation thesis
• The essential features of the Post Keynesian approach to
monetary economics are that credit and money are demand-led
endogenous variables, and that central banks can control
interest rates, within large bounds.
• Through the reflux principle, balance of payments disequilibria
have no effect on the overall monetary base or money supply,
even with fixed exchange rates. Money aggregates are still
determined by demand-led factors. The only difference is that
these foreign-induced disequilibria will change the composition of
the balance sheet of the central bank.
• As Arestis and Eichner (1988: 1018) say, “government deficits
and a favorable balance of payments have no direct effect on the
creation of money, for any money thus created is completely
compensated by an equivalent reduction in credit money”.
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A PK, more realistic, balance sheet of
central banks, with compensation
Assets
Liabilities
Foreign reserves
Banknotes
Bank deposits (bank
reserves)
Claims on domestic
government (Treasury bills)
Government deposits
Claims on domestic banks
(advances)
Central bank bills
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History shows that the rules of the game never
held, even during the gold exchange regime
• Bloomfield (1959, p. 49) shows that when looking at year-toyear changes in the period before the First World War – the
heyday of the gold standard – the foreign assets and the
domestic assets of central banks moved in opposite directions
60% of the time. Foreign assets and domestic assets moved
in the same direction only 34% of the time for the eleven
central banks under consideration.
• The prevalence of a negative correlation thus shows that the
so-called Rules of the Game were violated more often than
not, even during the heyday of the gold standard. Indeed, ‘in
the case of every central bank the year-to-year changes in
international and domestic assets were more often in the
opposite than in the same direction’ (Bloomfield, 1959, pp. 4950).
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Further results
• Almost identical results were obtained in the case of the
1922-1938 period.
• Ragnar Nurkse (1944, p. 69) shows that the foreign
assets and the domestic assets of twenty-six central
banks moved in opposite direction in 60% of the years
under consideration, and that they moved in the same
direction only 32% of the time.
• Studying the various episodes of inflows or outflows of
gold and exchange reserves, Nurkse (1944, p. 88)
concludes that ‘neutralization was the rule rather than
the exception’. Without saying so, Nurkse adopts the
compensation principle as the phenomenon ruling
central banks in an open economy. The rules of the
game as they were to be endorsed in the modern
IS/LM/BP models of Mundell are an erroneous depiction
of reality.
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The compensation thesis
• Bloomfield and Nurkse have uncovered what was later to be
called the compensation thesis.
• The compensation thesis is sometimes called the Banque de
France view, because in its modern incarnation it was endorsed
by Pierre Berger, who was the general director of research at
the Banque de France.
• Berger (1972a, 1972b) points out that the compensation
phenomenon that can be observed in modern economies could
already be observed in the 19th century.
• Berger argues that when France had large external surpluses,
and hence was accumulating gold reserves, the peaks in the
gold reserves of the Banque de France were accompanied by
throughs in credits to the domestic economy.
• As a result, despite the wide fluctuations in gold reserves, the
variations in the monetary base and the money supply were
quite limited.
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Nurkse and the compensation thesis
• “There is nothing automatic about the mechanism
envisaged in the “rules of the game”. We have seen
that automatic forces, on the contrary, may make for
neutralization. Accordingly, if central banks were to
intensify the effect of changes in their international
assets instead of offsetting them or allowing them to
be offset by inverse changes in their domestic assets,
this would require not only deliberate management
but possibly even management in opposition to
automatic tendencies.”
• (Nurkse, 1944, p. 88)
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Active sterilization or
passive compensation?
• Nurkse’s rejects the standard interpretation in terms of a
‘sterilization’ operation initiated by the central bank.
• Nurkse considers that it would be ‘quite wrong to interpret [the
inverse correlation] as a deliberate act of neutralization’ on the
part of the central bank.
• On the opposite, Nurkse considers that the neutralization of
shifts in foreign reserves is caused by ‘normal’ or ‘automatic’
factors, and that the compensation principle operates both in
overdraft financial systems and in the asset-based ones.
• In the overdraft system, Nurkse (1944, p. 70) notes that ‘an
inflow of gold, for instance, tends to result in increased
liquidity on the domestic money market, which in turn may
naturally lead the market to repay some of its indebtedness to
the central bank’.
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Active sterilization or
passive compensation? (2)
• But Nurkse also observed compensating phenomena that were
consistent with the operation of an asset-based financial system.
• In the case of an inflow of gold and foreign exchange, foreign
investors (or the banks where their deposits would be held) would
purchase new government securities.
• This would allow Government to reduce its debt to the central bank,
as would be the case in an open-market operation.
• However, as Nurkse (1944, p. 77) points out, in contrast to the
usual open-market operation, the manoeuvre ‘did not come about at
the Bank’s initiative’.
• Alternatively, Nurkse (1944, p. 76) points out, gold inflows could
also be neutralized by an increase in government deposits held at
the central bank, as the Bank of Canada used to do.
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Even Keynes recognized the
compensation principle
• Keynes (1930, ch. 32) was also keenly aware of the
compensation phenomenon.
• He points out that year after year the Bank of England
would gain £10,000,000 of gold in the spring and lose a
similar amount in the autumn. This should have caused
concern to all, but it did not, because these inflows and
outflows were compensated by corresponding seasonal
outflows and inflows arising from the Treasury.
• In the spring, with the receipts of income tax, the Treasury
would buy back its securities from the public and from the
Bank of England, thus reducing the domestic credit entry
in the balance sheet of the Bank of England.
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A PK, more realistic, balance sheet of
central banks
Assets
Liabilities
Foreign reserves
Banknotes
Bank deposits (bank
reserves)
Claims on domestic
government (Treasury bills)
Government deposits
Claims on domestic banks
(advances)
Central bank bills
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UNQ, Argentina, 2012
An obvious case of endogenous
sterilization: Germany
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The Canadian case, before giving up
exchange rate interventions in 1997
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The case of Argentina (Frenkel and Rapetti 2008)
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Central banks always pursue sterilization
and say so
• In a background paper, the Bank of Canada (2003) explains that when it
conducts exchange rate operations, moderating a decline in the Canadian
dollar for instance, it must sterilize its purchases of Canadian dollars by
‘redepositing the same amount of Canadian-dollar balances in the financial
system’, in order ‘to make sure that the Bank’s purchases do not take money
out of circulation and create a shortage of Canadian dollars, which could
put upward pressures on Canadian interest rates’.
• Similarly, when the Bank wishes to slow down the appreciation of the dollar
and sells Canadian dollars on the exchange markets, thus acquiring foreign
currency, ‘to prevent downward pressure on Canadian interest rates ... the
same amount of Canadian-dollar balances are withdrawn from the financial
system.’.
• Thus sterilization is not a matter of choice, it is a necessity as long as the
central bank wants to keep the interest rate at its target level.
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The current Eurozone case
• What happens if depositors move their money away from PIIGS
banks or if the PIIGS run a current account deficit?
• Normally such imbalances are absorbed by counteracting
movements in the overnight or wholesale funds markets.
• However, Northern banks are now declining to provide loans to
Southern banks.
• Assume Italy has a current account deficit, importing too many
goods, while Germany has a current account surplus.
• The TARGET2 system will absorb all this smoothly.
• Compensation phenomena will also arise.
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Banca Nazionale
del Lavoro (BNL)
Bank of Italy (BI)
Deutsche Bank
(DB)
Asset
Liability
Asset
Liability
Asset
Deposit
importer
-10
Advance
from BI
+10
Advance
to BNL
+10
Deposit
importer
-10
Advance
from BI
+10
Advance
to BNL
+10
Bundesbank (BB)
Liability Asset
Liability
Advance
Reserves
from BB +10 at BB +10
Deposit
exporter
+10
Advance to
BI +10
Deposit
of DB +10
Due to the
eurosystem
+10
Deposit
exporter
+10
Advance
from BB 10
Claims on
the
Eurosystem
+10
Advance to
DB -10
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ECB
TARGET 2 balance
Asset
Liability
Debit
Credit
position position
of BI +10 of BB +10
Sterilization at the Bundesbank
Target2
balances
Claims
on banks
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There is no need for sterilization (in a BOP surplus
position) when there is a floor system (Switzerland JulySeptember 2011, with target rate at 0 to 0.25% !)
Interest rate
ceiling
S July
S’ Sept
Lending rate
Demand for reserves
Target rate and
Deposit rate
floor
0.25%
Reserves
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Godley stock-flow consistent (SFC)
models and the compensation thesis
• It can be shown that
interest rates can be kept
constant in a open
economy SFC model with
a fixed exchange rate and
a surplus or deficit BOP.
• Compensation will occur
automatically in such a
model.
2012
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The eurozone: Effect on various balances of an increase
in the propensity of the ‘& Greece’ country to import
products from the ‘$’ country (flexible euro/$ rate)
Germany
Greece
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Evolution of the assets and liabilities of the European Central Bank
following an increase in the propensity of the ‘& Greece’ country to
import products from the ‘$ USA’ country, so as to keep interest rates
equal in both countries. But the ECB, up until May 2010, refused to hold
government securities!
Greek T-bills
German T-bills
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