Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 2 August 2012

Currency Misalignments and Current Accounts

One of my favourite journal paper titles is Xavier Sala-i-Martin’s AER paper ‘I just ran two million regressions’. The problem that paper tries to deal with is that there are too many potential variables that you could conceivably put in an equation explaining differences in economic growth rates among countries. There is then a serious danger of (intentional or otherwise) data mining. A researcher may want to establish that their pet new variable is important in determining growth, so they try lots of different regressions. When one set of additional variables are included the pet new variable is significant, but when another set is used it is not. Only the first group of regressions are published. Sala-i-Martin’s paper uses techniques that involve looking at all possible permutations of variables, in order to try and assess which are robust, in the sense of tending to be significant whatever else is in the regression.  

A recent ECB working paper by Ca’Zorzi, Chudik and Dieppe does something similar with models of the medium term current account. Why is this important? In my view it’s a key ingredient in being able to say something about exchange rate misalignments. This idea is associated in particular with the work of John Williamson, who christened the approach Fundamental Equilibrium Exchange Rates, or FEER for short. (That led to probably the best title of any of the papers I have co-authored – ‘Are Our FEERs justified’ – where we test the FEER approach against PPP[1].) John’s most recent analysis, co-authored with William Cline, can be found here. This or very similar approaches often go by different names: in Peter Isard’s nice survey it is called the macroeconomic balance approach, and it continues to be used (along with other methods) by the IMF.

The idea behind the FEER approach is to model trade flows as a function of the real exchange rate and activity levels. In the medium term activity levels will be determined from the supply side i.e. the output gap will tend to zero. So if we think we know about this supply side, and we know what the current account will be in the medium term, we can back out the medium term real exchange rate. We can then form a view about the extent to which current exchange rates are misaligned (or, more precisely, what expected interest rate differentials would have to be to justify current exchange rates). I’ve used this approach on a number of occasions in the past: perhaps most notably, to try and assess what Euro/Sterling exchange rate the UK should have entered the EuroZone at if it had decided to join in 2003.

The main problem with this approach is working out what the medium term current account should be. Actual current accounts are a poor guide, because they are influenced by both noise and short term factors, like the economic cycle and currency misalignment. In long term equilibrium it is reasonable to assume that the current account should be zero, because the current account is the change in national wealth. However we know that current accounts can show persistent surpluses or deficits over many years. Intertemporal consumption theory gives us some ideas, but on its own it is not that helpful. Many other factors may matter, such as countries having different demographic profiles.  With no clear encompassing theory to use, empirical studies of the kind cited above may be our best guide.

Incidentally, the New Open Economy Macro (NOEM) approach, which is currently the most widely used microfounded open economy framework, essentially uses the same idea as the FEER: see for example this study by Obstfeld and Rogoff. It is more concerned with microfoundations, and less with data, but it shares with the FEER approach a focus on imperfectly competitive markets for internationally traded goods. As far as I know these authors have never acknowledged Williamson as a precursor, and I’m not sure why. As a result, many macroeconomists think NOEM invented this way of thinking about medium term exchange rates.

The details of which variables the authors of the ECB study find are important in determining medium term current accounts are probably not of wide enough interest to discuss in this post. What is more topical is that they use their robust models to estimate what underlying current accounts currently are for the US, UK, Japan and China. Perhaps unsurprisingly they find that, although the US would be in deficit and China in surplus, the numbers are much smaller than the deficits and surpluses observed in the recent past. More controversial, perhaps, is that they find Japan should also be running a deficit. In the past I and others have tended to assume surpluses for Japan, but this was always partly based on demographic features which were coming to an end, which is maybe what has now happened.

One slightly disappointing aspect of the study is that they did not look at Germany. There is some debate about the extent to which German surpluses represent a temporary misalignment of real exchange rates within the Eurozone, or whether they may be partly structural. The answer is rather important in assessing the extent to which deflation is required outside Germany, and it would have been very interesting to know what this study had to say on this issue.                   

[1] I should add that I take no credit for the title - I think it came from Rebecca.


  1. If I'm thinking of Switzerland, where you recently paid an astronomical sum of money for a bottle of water and where I live, it is difficult to understand how the Swiss economy can remain competitive with an exchange rate that makes its goods so costly. Switzerland has consistently been topping the charts of the Economist's Big Mac index for years, and it still does now even if the Swiss franc is artificially pegged to the euro (a necessity imposed by the euro crisis). Yet, Switzerland has a trade surplus and an unemployment rate of 3%.
    Like Japan, Switzerland has low domestic competition, while the export industries focus on high added value-added goods and services.
    The technological edge, plus Chinese taste for prestige watches, and Swiss banks attracting worldwide money, prevail over PPP for the moment. In a sense, export industries subsidize the domestic economy, and especially professions and sectors that benefit from market protection (rent-seekers).
    Now, if the euro breaks in two or more parts, The Swiss franc will remain (naturally) linked to the stronger currency. Bottled water will be even more expensive for foreigners and trade balance would quickly return to the equilibrium.
    The problem is that this equilibrium will not be felt the same by everyone. Rent-seekers will retain their rent, while export industries will have to lay-off "en masse".

    1. I have never done any work on Switzerland, but it sounds like a clear example of where PPP analysis can be so misleading, and FEER calculations based on actual trade flows a much better guide to sustainable exchange rates.

  2. The last sentence-"The answer is rather important in assessing the extent to which deflation is required outside Germany..."

    Why couldn't you restate that as 'the extent to which inflation is required within Germany'? By all accounts that I know of, deflation is a slow, painful, grinding process that throws many people out of work causing immense harm to much of the populous. Who does moderate inflation, as in 4-6% per year, really hurt? Is it really comparable?

  3. Peter Montiel has extensively worked on this issue. He deals with it in his book Macroeconomics in Emerging Markets, by Peter Montiel.

  4. The response is rather essential in evaluating the level to which deflation is needed outside Germany, and it would have been very exciting to know what this research had to say on this problem.

  5. Dear Simon Wren-Lewis, your post is very interesting.

    I am a PhD candidate who work on equilibrium exchange rates inside the euro area. We have (with my PhD supervisor, Jacques Mazier) estimated equilibrium exchange rates for European countries thanks to a FEER approach. You can found the paper here:

    It appears clearly that the German undervaluation reflect structural improvements of the German economy in terms of competitiveness. The contrast between the equilibrium exchange rates of France and Germany is very striking.

    I agree with your the central issue is to estimate with a great precision the medium-term current account balances. In fact, the current account regressions are a good perfect of the problem cited by the AER and ECB papers.

    On your JIMF paper, I publish a paper in the spirit of your study. I found strong empirical evidence that FEER are co-integrated with REER for a large panel of industrialized and emerging countries over the period 1980-2007. You can find the paper here : Thus, we can considered that the FEER approach is a useful alternative to the PPP approach even for emerging countries.

    According to me, the most attractive feature of the FEER approach is that it take in account the systemic aspect of the problems caused by global imbalances. If some countries are undervalued and run large current account surplus then some other countries are overvalued and run large current account deficits. It sound like a truism but many people forget it when it talk about global imbalances and exchange rate misalignments.


    Jamel Saadaoui,
    University of Paris North.


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