Is sterling overvalued?

One of the reasons that steel plants have been closing in the UK rather than Germany or France, and that UK manufacturing output has fallen for the last two quarters, is the strength of sterling and the weakness of the Euro. The weakness of the euro relative to the dollar could be explained (at least qualitatively) by interest rate expectations: whenever interest rates do rise in the US, they will surely rise well before they do in the Eurozone. When domestic interest rates are expected to rise relative to overseas rates, a currency should appreciate.

The same logic could be applied to sterling. Indeed some still believe interest rates could rise in the UK before they rise in the US. If the UK looks like the US, you would expect on these grounds for the pound relative to the dollar to be roughly stable, but sterling to follow the dollar in appreciating against the Euro. To a first approximation that is what has happened.

The only problem comes if you look at the UK’s external performance. The current account deficit as a percentage of GDP has wobbled around 2% for most of this century, but in the last few years it has increased sharply, coming in at over 5% of GDP in 2014. All these deficits are taking their toll on the UK’s net financial position: twenty years ago we owned about as many overseas assets as there were UK assets owned overseas, but we are now a net debtor by an amount that will just get larger if we continue to run large current account deficits. (For more on this, see Felix Martin in the FT.)

When I calculated an equilibrium sterling euro rate in 2003, my estimate was 1.365 E/£. As current rates are close to that, and given the point about expected interest rates, what is the problem? Unfortunately there are three. First, that calculation was based on an assumption that the sustainable UK current account was balance. In other words, if the rate had stayed at 1.365 E/£, then over time and on average the current account should have been in balance. Instead we have had persistent deficits. In the early 2000s that might have been partly explicable because sterling was a little stronger than my estimate, but since the beginning of 2008 quite the reverse has been true, but we have still run deficits. That either suggests my estimate was wrong (the equilibrium E/£ rate should have been lower), or the equilibrium rate has depreciated since 2003.

Second, persistent current account deficits that weaken our net foreign asset position will in any case imply a gradual depreciation in the equilibrium exchange rate. The worse our net asset position gets, the greater the trade surplus we need to pay interest on that net debt. Third, and perhaps more speculatively, if the recent stagnation in productivity also represents a stagnation in innovation in the variety and quality of goods produced in the UK, that will also mean a depreciation in the equilibrium exchange rate.

All this suggests to me that sterling may currently be overvalued. How can I say this when there are a huge number of people in that market trying to make money from getting the ‘right’ rate? Quite simply from experience. The market is totally focused on very short term movements, and pays very little attention to estimates of equilibrium rates. When I did my equilibrium rate calculation in 2002, the actual rate was wandering around 1.6 E/£, and there was no clear reason why it should be so much higher than the equilibrium rate. So, even allowing for expectations about interest rates, it would be quite possible for sterling to be currently overvalued.          

What place do applied middlebrow models have?

Mainly for economists, although the jargon I cannot help using is not critical to the message

Paul Krugman writes that “the effect of the insistence that everything involve intertemporal optimization has been to drive out middlebrow economic modeling.” I like the term middlebrow. A ‘highbrow’ is ‘One who possesses or affects a high degree of culture or learning’, and I think that has a nice ambiguity to it.

Paul gives a couple of examples where middlebrow research is getting squeezed out. I want to add an applied example of my own which I believe shows clearly that there is a problem, but also why there is no simple answer. The story is a little on the long side, but telling it provides evidence of a pattern which is my main point.

I first started working on the calculation of equilibrium exchange rates with Ray Barrell in the late 1980s. The partial equilibrium model we constructed, looking at the G7 currencies, was based on an approach pioneered by John Williamson, which he called the FEER. This essentially uses trade equations to estimate the exchange rate which would produce an off-model guess at a ‘sustainable’ current account. If you want to think of it in terms of a two dimensional diagram, think about a supply and demand curve in real exchange rate/output space (sometimes called the Swan diagram: see this post for example.) It is a good example of a well used middlebrow model. What FEER analysis effectively does is estimate the demand curve, conditional on off-model assumptions about asset accumulation.

Our paper attracted a lot of interest, and we did send it to a couple of journals. However the response was consistent: the model was rather traditional, partial equilibrium, not microfounded, and therefore of not enough interest for a major journal. All this was true, so we gave up on publication. However the UK was about to enter the ERM, so we used the model as part of a comprehensive analysis of an optimal entry rate. Our analysis, published by the Manchester school as part of a conference volume, suggested that the rate we did join the ERM at - 2.95 DM/£ - was too high and would intensify the recession. Subsequent events did not prove us wrong. [1]

In the late 1990s John Williamson asked me to update the analysis, which I did with Rebecca Driver. It was published as a monograph, and neither of us thought it worth the effort to go for what we knew would be a minor journal publication. 

In 2003 the UK government had to decide whether to join the Euro. It undertook a number of background studies to help it make that decision, but it also needed to know what rate to enter at if they decided to join. Initially they asked me to review existing studies on what the equilibrium Euro/Sterling rate might be. There were no papers (microfounded or not) published in top journals. I focused on three studies: my earlier work with Driver, one available as an IMF working paper, and one published in a policy oriented journal. They then asked me (in 2002) to update my own earlier estimates, which I did with a new model of the yen, dollar, euro and sterling. At the time the exchange rate had been around 1.6 Euro/£ for over 2 years - I calculated that the equilibrium rate was a little below 1.4 E/£. By the time the study was published in 2003 the rate had fallen to around 1.45 E/£, and it stayed near that level until 2007.

There is a lot to say about that work, including a rather amusing incident that happened just after the study was published, but that is for another day. The point I want to make here is that I did not even try to publish this 2002 exercise. I feel rather guilty about this now, because the study is so hard to find. [2] Yet as an academic the incentives for me to publish in a minor policy orientated journal were zero.

John Williamson’s FEER framework anticipated aspects of the New Open Economy approach. In the mid 2000s Obstfeld and Rogoff applied (without as far as I know acknowledging Williamson) a similar approach to an analysis of the US exchange rate and current account, at a time when many people thought the financial crisis would be all about the dollar. The best known example of this work was published as a Brookings paper. Their analysis is microfounded in the sense that it includes deep parameters like demand elasticities, but it remains partial equilibrium and there is nothing intertemporal. Their microfoundations focus is elegant, but its output is more limited: they only calculate the impact of a given US current account change on equilibrium exchange rates, and do not try and estimate what equilibrium rates actually are. However the point I want to make here is that this was analysis of key interest, undertaken by two of the best international macroeconomists in the world, but it was not published in one of the top six journals. [3] [4] [5]

It is not difficult to see why. There is little here to interest either a theorist or an econometrician. The theory is well known, and models are either calibrated or involve very simple estimation. Yet constructing a model (microfounded or middlebrow), and taking it to the data, is a non-trivial task, and there are plenty of ways to get nonsense out. I use a lot of skill and experience in this work. (You could say they are the skills and experience of an engineer or experimental scientist, rather than those of a theorist.) More importantly, the output is of considerable interest to policymakers and others. Every time someone says a currency is under or overvalued they are making a judgement about equilibrium exchange rates.

Now I suspect a lot of academic macroeconomists would say that this is the kind of work that should be done in policymaking institutions, and not by academics. Yet I kept being asked to update my work, and I guess Obstfeld and Rogoff did theirs, because policymaking institutions - with the important exception of the IMF - typically do not have the resources to maintain and develop models of this kind. Indeed increasingly I suspect that because it will not be published in good journals they infer that it is somehow not worth doing. [6]

I cannot help feel that there is some kind of ‘knowledge failure’ here, and that it is fairly specific to macro because macro involves models. This is not frontiers of research stuff, so you can see why you would not find it in the journals that leading theorists or econometricians would routinely read. My work was an empirical application of a middlebrow model, but still in my view the most reliable method we have at calculating equilibrium rates. It is quite consistent with a microfounded approach, but the microfoundations themselves are not terribly interesting. It can be very important (suppose we had joined the Euro in 2003), yet I did not have the incentive to even try and publish what I had done. Isn’t that rather strange?

[1] We published our analysis before we joined the ERM. A well known FT journalist told me at the time that he thought we had won the intellectual argument, but he still felt instinctively that 2.95 was the right rate to enter at. The UK government also followed their instincts, with disastrous results.

[2]  It recently took me 30 minutes to find a ‘snapshot’ from the Treasury website hosted in the national archives where the links worked - thanks HMT!

[3] This update of my Treasury analysis (published as a book chapter) has an appendix which goes through the microfoundations of the FEER approach. I could talk about the relative merits of a microfoundations centred approach and my more data based FEER approach, but that is not the key point I want to make here.

[4] Why not make the model general equilibrium using intertemporal theory to model the current account, for example? Unfortunately the standard intertemporal model is hopeless at describing trends in the data, yet matching trends in the data is vital in calculating equilibrium exchange rates. I essentially make the same point here when discussing the US savings ratio. There have been empirical studies of medium term current accounts (I discuss a recent one here), but these are reduced form and pretty ‘ad hoc’ by today’s standards. Again you will not typically find these studies in the top journals.

[5] Why is publication in top journals important? Because that gives the best economists the incentive to try and improve or develop work, and therefore to get even better answers. Policymakers asking economists like me to do occasional work is fine, but you really want a forum where others can – uninvited – critique and improve on that work, and which provides a memory so that new work does not ignore what has gone before.  

[6] You might be tempted to say that if this analysis was any good, those involved in the FOREX market could make money from it. I have been in a number of meetings with people like that, and they are interested until they ask how long an exchange rate might typically take to get to its equilibrium rate. When I say around 5 years, they nearly always lose interest! For those who think all you need at this horizon is PPP, read this.

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.                   

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

Correcting Eurozone Imbalances

I have been thinking about the extent to which real exchange rate misalignment within the Eurozone (essentially most countries have lost competitiveness with Germany) requires austerity outside Germany. I have argued that a much tighter fiscal policy (austerity) outside Germany would have been a good idea before 2007 to prevent these imbalances occurring in the first place. However that does not necessarily imply it is required now, for two reasons. First, misalignment is eventually self-correcting, as less competitive countries sell less goods etc. Second, perceived debt risk which is driving up long term interest rates provides an additional deflationary force in many of these uncompetitive countries.

                This question is essentially a forecasting issue, so I looked at the OECD Economic Outlook forecasts. The table below comes from there. It contains a bit of a puzzle. If you look at unemployment rates, you see just the kind of pattern you would expect if correction was underway (except perhaps for Italy). German unemployment is way below the Eurozone average,  and the German average level in the decade before the recession, whereas the opposite is true for Ireland and Spain. The OECD’s calculation of the output gap tells the same relative story: everyone is below the non-inflationary level of output, but Germany by not that much, and Ireland and Spain by much more.

                If we look at inflation, however, we get a much more depressing story. Take the GDP deflator (the price of domestically produced output) for example. Inflation in Ireland is less than 1% below Germany, and that is the most favourable comparison. The signs of real exchange rate correction are weak.  

                There are two possibilities here. One possibility is that these inflation forecasts are way too conservative. In particular, low unemployment in Germany will lead to more rapid inflation than is forecast here. The alternative story is that the inflation forecasts are broadly correct, and they illustrate both the difficulty in getting inflation down outside Germany when it is so close to zero, and the difficulty in getting inflation up in Germany when its economy remains depressed. In particular, if the output gap number is right, then it is hard to see German inflation rising much above 2%. 

	Unemployment (%)				Output Gap	Ave Forecast Inflation % 2011-13
	1998-2007	2011	2012	2013	2011-13	Compensation	GDP	Consumer prices
Eurozone	8.6	10.1	10.4	10.1	-3.2%	2.1	1.3	1.8
Germany	8.8	5.7	5.7	5.4	-1.2%	2.4	1.1	1.8
Ireland	4.8	14.2	14.0	13.4	-7.1%	1.7	0.4	0.9
Spain	10.6	22.5	23.0	22.4	-5.7%	1.9	0.8	1.8
Italy	8.7	8.1	8.4	8.7	-2.3%	2.1	1.4	1.8
France	8.8	9.4	9.9	9.8	-4.2%	2.6	1.3	1.5

Is there a Competitiveness Problem within the Eurozone?

Many economists, including myself, have argued that there are two crises in the Euro area right now. The one everyone knows about involves government debt. But the other involves competitiveness. Most Eurozone countries (let’s call them non-Germany for short) have allowed their inflation rates to exceed German inflation for a sustained period, which means they are now seriously uncompetitive relative to Germany. This situation will inevitably correct itself. However if German inflation remains low, correction will involve a period of static or falling prices for non-Germany. From experience we know this can only be achieved by high unemployment and low, possibly negative, growth in non-Germany. As a result, many Eurozone countries might be facing or experiencing a recession even if there was no debt crisis.

                But does the data support this proposition, which we might call the ‘current misalignment’ hypothesis. The chart below looks at relative unit labour costs (a measure of competitiveness often used by the OECD, whose Economic Outlook is the source for this data) for Germany and the Eurozone as a whole.

Relative Unit Labour Costs

The level of either series is arbitrary – its changes that matter. German competitiveness has stayed fairly constant over the last twenty years, but Euro competitiveness has declined sharply since its formation. This implies an even larger competitiveness decline in non-Germany.

                So movements in competitiveness since 2000 are clear. However there is an alternative to the current misalignment hypothesis. It could be that the Euro started with an uncompetitive Germany, because Germany joined at an overvalued exchange rate. Let’s call this the ‘past misalignment’ hypothesis. Perhaps what we see now is a return to sustainability rather than a movement away from it. The chart indicates this possibility, with non-Germany gaining competitiveness between 1992 and 2000.

                Unfortunately we cannot make the assumption that competitiveness always reverts back to some constant level. For reasons that we do not fully understand, what we call equilibrium real exchange rates (trend or sustainable competitiveness) can show trends over time. So how do we judge what level of competitiveness is sustainable, and what is not? In 1998 I published some work with Rebecca Driver that estimated equilibrium exchange rates for the year 2000. The equilibrium rates we calculated for the Franc/DM and Lire/DM turned out to be close to their Euro conversion rates. This suggests no German misalignment when the Euro was created. At its most basic, what this study did was to look at current accounts.

                If a country is too competitive (its exchange rate is undervalued) it will run a current account surplus, and vice versa. The chart below shows a sharp switch from small deficits to large surpluses in the German current account after the formation of the Euro. Non-Germany shows the opposite pattern.

              

If (and this will be a big if) a sustainable exchange rate is associated with current account balance, then this evidence strongly supports the current misalignment idea. Many have argued (e.g. Martin Wolf in the Financial Times) that current accounts indicate that the Eurozone does indeed have two crises at present. Daniel Gros  goes further, and suggests external debt is the key to the current turmoil in European economies.

                But is a current account surplus or deficit a sure fire indicator of unsustainable competitiveness? As the current account represents changes in national wealth, we would expect that in a very long run equilibrium the current account should balance. However that is not the case over periods of, say, a decade or two. There are many examples of countries that run persistent current account surpluses: Japan is the obvious example. We understand some reasons why this might happen: a country may have a demographic structure where there are more savers than borrowers (with the opposite bias overseas). Perhaps the formation of the Euro started a period where more capital flowed from the richer to the poorer Euro economies. But if that were the case, would we not also expect surpluses in France, whereas what we find are deficits. Some arguments go the other way. If the need for fiscal consolidation was greater in non-Germany than Germany, this might imply that non-Germany would run larger current account surpluses for some time.

                Empirical evidence is rarely clear cut in macro. We cannot know for sure that over the next decade or two Germany will not continue to run large surpluses and non-Germany deficits. But – based on the evidence that I have seen – it does seem unlikely. This past misalignment story seems less plausible and the current misalignment hypothesis more credible. Some interesting implications follow, which I intend to explore later.