Search This Blog

Showing posts with label money supply. Show all posts
Showing posts with label money supply. Show all posts

Sunday 18 June 2023

Economics Essay 79: Floating Exchange Rates

 Explain how a government or central bank can intervene to prevent the value of its currency rising.

A government or central bank can intervene in the foreign exchange market to prevent the value of its currency from rising through various measures. Here are some common interventions:

  1. Foreign exchange market operations: The central bank can directly buy or sell its own currency in the foreign exchange market. If the currency is appreciating, the central bank can sell its own currency and buy foreign currencies, increasing the supply of its currency in the market and reducing its value. Conversely, if the currency is depreciating, the central bank can buy its own currency and sell foreign currencies to decrease the supply and increase the value of its currency.

  2. Monetary policy adjustments: The central bank can implement monetary policy measures to influence the value of the currency. For instance, it can decrease interest rates or engage in quantitative easing, which increases the money supply. These actions can make the currency less attractive to foreign investors, leading to a decline in its value.

  3. Capital controls: Governments can impose restrictions on capital flows to prevent excessive inflows of foreign capital that could lead to currency appreciation. They may impose limits on foreign investment, restrict the repatriation of funds, or implement taxes or levies on certain capital transactions. These measures aim to reduce the demand for the domestic currency and prevent its value from rising.

  4. Intervention coordination: Governments or central banks can coordinate with other countries to intervene collectively in the foreign exchange market. This can involve joint actions to buy or sell currencies to stabilize exchange rates and prevent excessive currency fluctuations.

It is important to note that currency interventions are subject to certain limitations and can have both short-term and long-term effects. Here are some considerations:

  1. Effectiveness: The impact of currency interventions may vary, and their effectiveness in influencing exchange rates depends on market conditions, the size of the intervention, and the overall economic factors at play.

  2. Costs and risks: Currency interventions can involve significant costs and risks. For example, buying or selling large amounts of foreign currencies can deplete foreign exchange reserves, potentially leading to reduced financial stability. Moreover, interventions may be seen as market manipulation, potentially undermining investor confidence.

  3. Policy credibility: Frequent or unpredictable interventions can raise questions about a government's or central bank's commitment to market principles and exchange rate stability. This can erode market confidence and have unintended consequences.

  4. Trade implications: Currency interventions can affect trade competitiveness. A weaker currency may make exports more competitive but also increase the cost of imports, potentially impacting a country's trade balance.

Overall, currency interventions can be a tool for governments or central banks to manage exchange rate movements. However, their effectiveness and appropriateness depend on specific circumstances, and policymakers need to carefully consider the potential costs, risks, and trade-offs associated with such interventions.

Monday 17 October 2011

How Quantitative Easing will not solve the problem - An alternative viewpoint

Professor Steve Keen was one of the few economists to predict the financial crisis. According to him, the “debt-deflationary forces” unleashed today “are far larger than those that caused the Great Depression.”

I stumbled out into the autumn sunshine, figures ricocheting around in my head, still trying to absorb what I had heard. I felt as if I had just attended a funeral: a funeral at which all of us got buried. I cannot claim to have understood everything in the lecture: Sonnenschein-Mantel-Debreu Theory and the 41-line differential equation were approximately 15.8 metres over my head(1). But the points I grasped were clear enough. We’re stuffed: stuffed to a degree that scarcely anyone yet appreciates.

Professor Steve Keen was one of the few economists to predict the financial crisis. While the OECD and the US Federal Reserve foresaw a “great moderation”, unprecedented stability and steadily rising wealth(2,3), he warned that a crash was bound to happen. Now he warns that the same factors which caused the crash show that what we’ve heard so far is merely the first rumble of the storm. Without a radical change of policy, another Great Depression is all but inevitable.

The problem is spelt out at greater length in the new edition of his book Debunking Economics (4). Like his lecture, it is marred by some unattractive boasting and jostling. But the graphs and figures it contains provide a more persuasive account of the causes of the crash and of its likely evolution than anything which has yet emerged from Constitution Avenue or Threadneedle Street. This is complicated, but it’s in your interests to understand it. So please bear with me while I do my best to explain.

The official view, as articulated by Ben Bernanke, chairman of the Federal Reserve, is that both the first Great Depression and the current crisis were caused by a lack of base money. Base money, or M0, is money that the central bank creates. It forms the reserves held by private banks, on the strength of which they issue loans to their clients. This practice is called fractional reserve banking: by issuing amounts of debt several times greater than their reserves, the private banks create money that didn’t exist before. Conventional economic theory predicts that when the central bank raises M0, this triggers a “money multiplier”: private banks generate more credit money (M1, M2 and M3), boosting economic growth and employment.

Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was propelled by a fall in the supply of M0, which, he said, “reinforced … declines in the money multiplier.”(5) But, Keen shows, there is a weak association between M0 money supply and depression. There were six occasions after World War Two when M0 money supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s(6). In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results which defy Bernanke’s explanation. Steve Keen argues that it’s not changes in M0 which drive unemployment, but unemployment which triggers changes in M0: governments issue more cash when the economy runs into trouble.

He proposes an entirely different explanation for the Great Depression and the current crisis. Both events, he says, were triggered by a collapse in debt-financed demand(7). Aggregate demand in an economy like ours is composed of GDP plus the change in the level of debt. It is the sudden and extreme change in debt levels that makes demand so volatile and triggers recessions. The higher the level of private debt, relative to GDP, the more unstable the system becomes. And the more of this debt that takes the form of Ponzi finance – borrowing money to fund financial speculation – the worse the impact will be.

Keen shows how, from the late 1960s onwards, private sector debt in the US began to exceed GDP. It built up to wildly unstable levels from the late 1990s, peaking in 2008. The inevitable collapse in this rate of lending pulled down aggregate demand by 14%, triggering recession(8).

This should be easy enough to see with the benefit of hindsight, but what lends weight to Keen’s analysis is that he saw it with the benefit of foresight. In December 2005, while drafting an expert witness report for a court case, he looked up the ratio of private debt to GDP in his native Australia, to see how it had changed since the 1960s. He was astonished to discover that it had risen exponentially. He then did the same for the United States, with similar results(9). He immediately raised the alarm: here, he warned, were the conditions for an economic crisis far greater than those of the mid-1970s and early 1990s. A massive speculative bubble was close to bursting point. Needless to say, he was ignored by policy-makers.

Now, he tells us, a failure to address these problems will ensure that this crisis will run and run. The “debt-deflationary forces” unleashed today “are far larger than those that caused the Great Depression.”(10) In the 1920s, private debt rose by 50%. Between 1999 and 2009, it rose by 140%. The debt-to-GDP ratio in the US is still much higher than it was when the Great Depression began(11).

If Keen is right, the crippling sums spent on both sides of the Atlantic on refinancing the banks are a complete waste of money. They have not and they will not kickstart the economy, because M0 money supply is not the determining factor.

President Obama justified the bailout of the banks on the grounds that “a dollar of capital in a bank can actually result in $8 or $10 of loans to families and businesses. So that’s a multiplier effect”(12). But the money multiplier didn’t happen. The $1.3tn that Bernanke injected scarcely raised the amount of money in circulation: the 110% increase in M0 money led not to the 800 or 1000% increase in M1 money that Obama predicted, but a rise of just 20%(13). The bail-outs failed because M0 was not the cause of the crisis. The money would have achieved far more had it simply been given to the public. But, as Angela Merkel and Nicholas Sarkozy demonstrated over the weekend(14), governments have learnt nothing from this failure, and seek only to repeat it.

Instead, Keen says, the key to averting or curtailing a second Great Depression is to reduce the levels of private debt, through a unilateral write-off, or jubilee. The irresponsible loans the banks made should not be honoured. This will mean taking many banks into receivership(15). Otherwise private debt will sort itself out by traditional means: mass bankruptcy, which will generate an even greater crisis.

These are short-term measures. I would like to see them leading to a radical reappraisal of our economic aims and moves to develop a steady-state economy, of the kind proposed by Herman Daly and Tim Jackson(16). Governments and central bankers now have an unprecedented opportunity to learn from the catastrophic mistakes they’ve made. It is an opportunity they seem determined not to take.


www.monbiot.com

References:
1. Professor Steve Keen, 6th October 2011. Alternative theories of macroeconomic behaviour: a critique of neoclassical macroeconomics and an outline of the alternative Monetary Circuit Theory approach. Nuffield College, Oxford.
2. Ben Bernanke, 20th February 2004. The Great Moderation. http://www.360doc.com/content/11/0402/23/67028_106822017.shtml
3. Jean-Philippe Cotis, May 2007. Achieving further rebalancing. OECD Economic Outlook. http://findarticles.com/p/articles/mi_m4456/is_81/ai_n27271380/
4. Steve Keen, 2011. Debunking Economics: revised and expanded edition. Zed Books, London.
5. Ben Bernanke, 2000. Essays on the Great Depression, page 153. Princeton University Press. Quoted by Steve Keen, as above.
6. Steve Keen, page 302.
7. Page 300.
8. Page 341.
9. Page 336-337.
10. Page 349.
11. Page 348.
12. Barack Obama, 14th April 2009. Remarks on the economy. http://www.whitehouse.gov/the-press-office/remarks-president-economy-georgetown-university
13. Page 306.
14. http://www.guardian.co.uk/business/2011/oct/09/france-germany-agree-plan-banks
15. Page 355.
16. http://www.monbiot.com/2011/08/22/out-of-the-ashes/