Will the Swiss event start a series of competitive devaluations?
In so far as we believe monetary policy in most countries is “too tight” there could be a significant upside to the Swiss decision to set a minimum value on their Euro change rate – if currency intervention is copied by most other countries it will lead to a loosening in monetary conditions.
Scott Sumner hints at this, and its an issue we’ve discussed here before. Although it is true that “not all countries can depreciate their currencies at once” they can devalue their currency relative to goods – they can create inflation. If there are risks of deflation, or inflation expectations are below the central banks target, such intervention could be justified.
Now, when writing about the Swiss event I wasn’t quite as confident. This was due to the fact that the Swiss actually went out and set a value on the currency – rather than just loosening policy.
I can understand why they did it, they felt there was an asset price bubble in their exchange rate – and they wanted to provide a lower focal point that traders could shift too (since expectations were driving the currency … note the increase in risk associated with intervention is also important). But if everyone sets “targets” there is the risk that we get an exchange rate regime where this rate doesn’t respond to changing economic fundamentals – and given that economic fundamentals change constantly, this is a concern.
“But if everyone sets “targets” there is the risk that we get an exchange rate regime where this rate doesn’t respond to changing economic fundamentals – and given that economic fundamentals change constantly, this is a concern.”
I think the problem is that exchange rates don’t respond to economic fundamentals. This is the point I was trying to make in the previous post (which I will return to when I’ve thought a bit more about it).
This may be due to the difference in actual overall capital flows where “fundamentals” are ignored by allocation of risk and investment capital e.g. investors happy to fund deficits and chase high yields at the same time (often one and the same). So deficit countries are not able to rebalance as one might expect.
My experience and observation suggests that this started with EMU convergence as investors chased yield, created new derivative structures, increased leverage and started financialising the investment game. The last 10 years saw this go into warp speed as the real economy was ignored and investing started to resemble a video game.
Hi Raf,
I agree that there are some issues with currencies responding to fundamentals – but I see this as a “symptom” of underlying issues, rather than something we try to mess around with directly.
Whenever a price is giving us poor information, we need to ask what sort of market failure we are seeing – I see a mix of institutional issues driving prices in funky directions, and I think any solution should be based on those issues rather than the currency per see.
Fixing currencies to try to solve it (which is my fear) is more than likely going to lead to worse outcomes