Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 21 October 2013

Is a currency crisis bad for you at the ZLB?

My and Paul Krugman’s comments on Ken Rogoff’s FT piece have generated an interesting discussion, including another piece from Ken Rogoff, a further response from Paul Krugman, and posts from Brad DeLong, Ryan Avent in the Economist, Matthew Klein, John McHale (follow-up here), Nick Rowe and Tony Yates. The discussion centred on the UK, but it is more general than that: a similar thought experiment is if China sells its US government debt. Paul Krugman has promised more, so this may be the equivalent of one of those annoying people in a seminar audience who try and predict with questions what the speaker will say.  

The track I want to pursue starts from my argument that Quantitative Easing (QE) will ensure that the UK government never runs out of money with which to pay the bills. The obvious response, which Paul Krugman’s comment took up, is that a market reaction against UK government debt might be accompanied by a reaction against the UK’s currency, leading to a ‘sterling crisis’. For those with a long memory of UK macro history, would this be 1976 all over again?

Ken Rogoff’s original article, and his reply, both focus on the trigger for these events being a collapse in the Euro. While such risks should be taken seriously (although, for the record, I have never thought such a break up was the likely outcome), I want to ignore this possibility here, simply because it introduces too many complicating issues. Instead I just want to look at a much more limited scenario. Specifically, suppose Labour had not lost the election, and austerity had been delayed (by more than Ken Rogoff would have thought wise, bearing in mind that he agrees that government ‘investment’ in its widest sense was in fact cut too aggressively). Suppose further that markets had decided that because of this alone it was no longer wise to buy UK debt. QE fills the gap, but the flight from UK debt is also a flight from sterling, which depreciates as a result. If the market believes the government is not solvent, it will assume some part of QE is permanent rather than temporary, so inflation expectations rise. This validates the fall in sterling, in the sense that the market does not see any capital gains to be made from its depreciation.

In this thought experiment the UK government is solvent before the crisis, so other things being equal QE will be temporary. We are not talking about a strategy of inflating away the debt. There are two directions we could follow at this point. One would be the idea that a depreciation makes the UK government insolvent: in other words the crisis is self-fulfilling. The analogy is with a funding crisis under a fixed exchange rate, where by pushing up the interest rate on debt, markets can induce the insolvency they fear. (The government was not insolvent under pre-crisis interest rates, but is insolvent if it has to borrow at post-crisis rates.) But its not clear how this would work when exchange rates are flexible. The depreciation would do nothing to raise current or future borrowing costs, or reduce the long term tax base. At some stage markets would realise their mistake. I cannot see why there are multiple equilibria here, but maybe that is a failure of my imagination.

The second direction is to focus on the short run costs of the nominal depreciation. Some of those who commented on my original post talked about a ‘downward spiral’ in sterling. Now of course the depreciation itself may raise inflation to some extent, but this is not an unstable process. At some point sterling falls to a point where the market now thinks it is OK to hold. There is no bottomless pit.

As domestic prices are sticky, the depreciation increases UK competitiveness, which increases the demand for UK goods. If the Zero Lower Bound (ZLB) is a constraint, then this increase in demand reduces or eliminates the constraint. It may also raise inflation because demand is higher, but higher demand is what monetary policy wanted but was unable to achieve. If the depreciation is so large that demand has to be reduced through increasing interest rates, that is fine: this is what monetary policy is for. In essence the ZLB is a welfare reducing constraint that the crisis relieves, and we are all better off.

If that sounds too good to be true, I think it could be. It treats the depreciation as simply a positive demand shock, that first eliminates the cost of the ZLB, and then can be offset by monetary policy. However a sterling crisis may also involve a deterioration in the output/inflation trade-off: equivalent to what macroeconomists call a cost-push shock. Take a basic Phillips curve. If agents start to believe inflation will be higher - even if these beliefs are incorrect (the crisis, and QE, is temporary) - while these mistaken expectations last this is a cost to the economy, because the central bank will have to raise interest rates to prevent these expectations fully feeding through into actual inflation. Either output will be lower, or inflation higher, or both.

Now as long as interest rates stay at zero, this is not a problem: the ZLB constraint still dominates. [1] However if the crisis was big enough, we could overshoot Brad DeLong’s sweet spot, and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much. First you have to believe that austerity, which reduces debt a bit more quickly than otherwise, is just enough to prevent a crisis, and then that the crisis is so big that it more than offsets the ZLB constraint. Unlikely, but it seems to be a coherent possibility.

But what about 1976, when pressure on sterling led the UK government to seek help from the IMF? Of course that was different, because we were not at the ZLB. I also suspect there were other differences. I was a very junior economist working in the Treasury at the time. I do not remember very much, but what I do remember was that there seemed to be a mindset among senior policy makers that sterling was on a kind of slippery slope. Once it started falling, who knows where it might end up? They seemed to believe there was a bottomless pit, and the IMF loan was required to stop us going there. I suspect that was in part just a lack of familiarity with how flexible exchange rates work. In the end, sterling did stabilise such that some of the IMF loan was not needed, and I wonder how necessary it really was. But if anyone who reads this post knows more about this period, I would be very interested in their thoughts.

[1] A possibility suggested by John McHale is that, although the interest rate set by the Bank of England could stay at its lower bound, there might be an increase in the interest rate spread, such that UK firms or consumers end up paying more. I’m not clear in my own mind why a depreciation would raise this spread. Even if the market believes the UK government is no longer solvent, the central bank still has the ability to prevent a run on UK banks. If the spread did increase, then programmes like Funding For Lending would still be possible.


  1. I think there is a counter to Krugman's basic argument (although I do not believe it accurate). Basically what I have in mind is that Krugman's discussion seems to take for granted that one is talking about a portfolio rebalance, rather than capital flight. If the Chinese, in this case, are unwilling to hold dollars, then it is unlikely they would be the only ones. Likely other countries would not be interested in exchanging for dollars, meaning there would be incentives for individual producers in the US to use alternative currencies or commodities in trade (with foreigners and others). This seems like it would be the road to Zimbabwe, but I also think this is clearly dead wrong, but there is a clear way to think about this possibility. It is hard to imagine that the Federal Reserve would be viewed as having no credibility where anything like this is possible and it seems even more unlikely because of the ZLB. Honestly, ridiculous...

  2. Just looking at the domestic currency bond financing issue, all the markets could really do is force a reduction in the duration in issuance.

    As a thought experiment, imagine that the Debt Management Office decided one day to finance the entire deficit with 50-year gilts. It is highly possible that it would not be able to issue all those gilts at practically any price, as market participants would be limited in their capacity to absorb the duration. Conversely, they have no problems issuing "unlimited" amounts of 6-month paper, as the banks and other speculators could buy almost without any limit, if there is a small spread over the expected path of short rates.

    Turning to a crisis, one could use this example to see that market segmentation and a reduction of demand could force the government to shorten maturities. So what? At the end of the day, they will still issue debt near rate levels set by the central bank. Those levels are set in order to hit desired policy targets, so it makes no sense to complain that they are "too high".

  3. A huge one time unpredicted revaluation of one currency compared to the others has usually as a consequnce that the people who receive the benefits see it as a windfall but the people who hold the other end of the stick get into financial trouble. Basically what you see in India cs and Japan now.

    Short term consequences are very likely negative. Longer term things will most likely work out. However as this is very likely done as a short term measure (one that needs to deliver short term results that is) not a good one. Gradual is the key.

    GBP goes faster down than the rest the last couple of years, but that process looks to have bottomed out.

    At the moment all major countries are having very similar policies (currency wise a race to the bottom) so hard to see why the UK in particular would get into trouble and the rest not.
    If countries get into trouble it is likely all.
    With the exception of the US. IF you will get some sort of system collapse the US will (currency wise at least) be hit much harder than the rest as its reserve currencystatus would be gone. Very likely face a Spanish/Greek type collapse. Deficits all over the place and requiring foreign lending which will not be there and no Germany to bail them out.
    You need real money at such a point as eg you have to pay your imports with them so printed stuff simply won't do.
    But nothing really points into a direction of a short term collapse.
    The US is clearly eroding fast its reserve curency status no doubt about that, but that looks to be a long term process not a short term one.
    (BTW any model that simply assumes that the reserve currency status will continue whatever happens simply has flaws in it).

    The UK is however probably a candidate for being next in line after the US (with Japan, but with other problems attached).
    Seeing from that more strategic perspective it would be nice if it could get its unbalances which depend upon foreign cooperation better under control.
    CA and trade in particular as starters.
    But later on private debt levels and especially sov debtlevels. The latter as that is where markets are mainly focussing on (if looking for the next victum). Both look high even at this moment and the trend is also not very helpful. However here it is priority setting (political aceptance, social rest, stimulus on the other side). Short term choices look clear, but that doesnot mean that there are no risks involved.
    Which by themselves simply need better management (UK being on of the better managed countries in that respect btw, so unlikely a first victum). But assuming that as things go well now they will continue that way is not the way to go. Simply hope als managementstrategy and hope is the mother of all f ups. You need better control. Less than the rest but better than it is now.

  4. “If the market believes the government is not solvent, it will assume some part of QE is permanent rather than temporary, so inflation expectations rise.”

    Why would “inflation expectations rise”? Assuming the UK government behaves rationally, and tries to emplement enough QE to cut unemployment to NAIRU (but no more), there is no reason to “expect” inflation.

    In general terms, any country that issues its own currency can at any time do some QE and cut it’s national debt (which includes some debt owed to foreigners). As to any excessive stimulatory effects of that QE, that can be countered by increased taxes. And as long as the relevant country doesn’t do anything too sudden or extreme (like trying to cuts it’s national debt to zero in one year), the markets have no good reason to take fright.

  5. As someone who mentioned the "downward spiral" in response to your first article, I think I should make some comment here.

    What prevents the downward spiral is either the fact or the expectation of a reversal of current policy. So, the markets will expect that, faced with a collapse of the currency, QE would be reversed, short rates would be put up and/or fiscal policy would be tightened. It is only when no action is taken (and when the market expects no action to be taken), that freefall can occur.

    So, I'd agree with you (as I did in my original comment) that the exchange rate would realistically bottom out, but this is only because the markets know that freefall will not be accommodated. The point though is that to do so, it that it may place a constraint on policy. I don't think this is inconsistent with what you are saying though, as in your scenario you are assuming that the government is able to reverse the QE at some point.

  6. Skidelsky has also just written on this Rogoff debate, Oct. 21, 2013, 'Misconceiving British Austerity', which includes two paragraphs on the 1976 IMF crisis.

    What I can add about 1976 is this:

    1. Real debt was lower 1979 when Labour left office than in 1974 (Middleton).
    2. July 1975 to July 1976 rates of increase in hourly wages fell from 33% to 18%, and second half of 1976 fell to below 10%. As such, the crisis at the end of 1976 was in no way associated with the failure to check wage inflation. 1973 current balance was in deficit, and 1974 peak deficit of £3,200 million, but it improved 1975 and 1976, until it was back in surplus in 1977. 1976 was the peak of foreign currency borrowing, £3,638 million in foreign exchange, and although the current account improved, the deficit was still £940 million. The 1976 forecast in the budget was £11.96 billion, but this was treated with scepticism given the past two years’ forecasts, especially when the July 1976 estimates were revised upwards. Even after large cuts in July and December 1976, the latter after the IMF visit, the PSBR was expected to be over £11 billion. But the quarterly figures – not then available! – show that the peak rate of increase had been reached in Q1 1976, and the cuts the IMF pressed for in November 1976 had already been made 6 months earlier without anyone knowing. The interest rate in UK fell Oct 1976 15%, Feb 1977 12%, May 1977 8%, October 1977 5%, due to the strengthening of sterling and an inflow of funds. Of the IMF loan, $1.2 billion drawn January 1977, $384 million in May 1977 and again August 1977 – less than half was used. As such, the 1976 IMF crisis was a problem of borrowing until international prices moderated and north sea oil came on stream. (Cairncross).

  7. Wages took an all time record share of GDP in the mid 1970s according to the chart here:

  8. Even if government deficits were the trigger, to what degree was the sterling crisis not a result of excessive government debt, but more fundamental - one of a balance of payments crisis caused by supply side factors - ie an unfavourable turn in the terms of trade (rel price of commodities vv that of industrial goods ala James Meade and Nicholas Kaldor). I do not think at this time Britain had the cushion of North Sea Oil. It is also not only an issue of having one's own currency. Spain, Italy, and Greece were basket cases before the Euro. Devaluation and inflation only masked the problem, and the divide between Southern and Northern Europe was there before and during the Euro. This is to do with the structure of their economies and fundamentally poor terms of trade positions (olive oil probably does not pay for petroleum and German industrial and consumer goods). The best route for these countries is closer integration, including at the fiscal level, with the German economy. Fiscal transfers from Germany, however are likely to demand acquiescence to German management of their funds, and are likely to face political obstacles in Germany. Overcoming this will require some evidence that Greece etc are getting their fiscal houses in order and cutting back on wasteful expenditure. This partly answers your earlier question, Simon, about why the Commission is pushing for austerity - it is to smooth the path for eventual fiscal union.

  9. A brief on BOP, TOT, sterling crisis

  10. Professor Wren Lewis it would be good if you could do a piece on the dollar's role as a reserve currency. Professor Krugman argues that "governments trying to prop their currencies up or hold them down often do so with trades against the dollar". And yet Britain tried very hard during the 1930s to keep the sterling based gold standard and preserve its international role. The EU seems to want to have the euro assume the status of a reserve currency. All this suggests some benefit to having such a currency. However, Krugman seems to think there is little advantage - ie it does not allow you to sustain large BOP deficits or enable you to borrow cheaply. Professor Krugman does not discuss the role of the US dollar as a safe haven, and why it is. Political and economic uncertainty only increase its demand. Has this enabled the United States to avoid a 1976 type Sterling crisis?

  11. Simon forget DSGE models, and go to the horse's mouth. This is from cabinet discussions, 1976 -

    " On the hand, those operating in the foreign exchange market
    already appreciated correctly the importance of the public
    sector borrowing requirement. They wanted to know that the
    Government were concerned about Its size and recognised
    the need to reduce it. There could be political advantages in
    early action on next year's borrowing requirement before any
    possible recourse to the IMF In the autumn.
    c. Although overseas opinion had taken some account of It,
    there had not yet been a full appreciation at home of the
    significance of the recently announced increase in the United
    Kingdom's recoverable reserves of gas and oil. The
    Department of Energy were endeavouring to produce more
    telling monthly statistics which would point up the value of
    these assets, upon which emphasis could also be laid at the
    Energy Conference later in the month. However, it was
    observed that foreign opinion had already taken full account of
    the value of the oil and gas reserves, and it was only for tills
    reason that the country had obtained help on the scale which
    had recently been arranged. The additional resource growth
    from North Sea oil and gas would be relatively small.
    THE PRIME MINISTER, summing up the discussion, said that..."


  12. Problems were identified with the Rogoff approach by some long before Reinhart-Rogoffgate.

    However the search and compilation of a large amount of historical data was brave and noble in an era where career advancement almost only comes with getting articles published in the AER or Journal of Monetary Economics that are conditional on tinkering of DSGE models. The problem was they spoiled a lot of fantastic work by rushing to conclusions and going for gimmick like an investment banker. An historian's work by its nature is meticulous and time consuming.

  13. You are being much too polite to Rogoff. For goodness sake's, the man is a PROVEN HOAX.
    He doesn't deserve to be treated with any respect at all.

  14. I think this analysis is fine as pure economics, but it totally ignores the political dynamics of a large and sudden currency depreciation, and therefore the likely actual rather than ideal policy response to it.

    Firstly, there are still an awful lot of awfully influential people who see the currency's value as a measure of national virility rather than as a technocratic control variable (true, fewer than in 1976 - but still). Secondly, a large and sudden currency movement has large and sudden distributional effects, whatever its aggregate effects. And losers scream far louder than winners cheer.

    You only have to see how much greater inflation-aversion is among creditors than debtors to understand that aggregate costs and benefits are not the politically relevant variables. "Sound money" was ever the concern of those with money, not those without - and those with money always make the rules.

  15. I think people who think devaluations are wonderful think in terms of the IS-LM-BP model. This is a good example of the over-reliance on models in economics (and especially international agency economists like the IMF) and this belief you can simply apply the same framework everywhere and go beyond using it as a simple reference point. Better to start with the fundamentals. For example, some countries are highly dependent on imported inputs for their exports (Australia, for example.). A devaluation can actually make their exports more uncompetitive and worsen their trade balance. For a small open economy, this can be serious.

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