A hypothetical chat – exchange rate overvaluation

With people in NZ constantly yelling about the dollar, and yelling at the Reserve Bank, I thought I would host a hypothetical discussion that hopefully helps to explain the issues – and why inflation targeting isn’t the cause of any of the perceived problems.  Here it goes:

Intelligent non-economist (INE):  The dollar is too high, and its destroying New Zealand’s economy.

Nolan (N):  Rightio, why.

INE:  When the dollar is too high, productive industries don’t have an incentive to produce or be here, so it hollows out the country.

N:  The dollar is a relative price.  If the price is too high, we need to ask why it is too high – and we need to take into account what other countries are doing.

INE:  Exactly.  Other countries are devaluing their currency and we are not because we are obsessed with inflation targeting.

N:  Not really.  Other countries are setting monentary policy to reach their inflation mandate, and so are we.  With a whole bunch of countries all targeting inflation outcomes of “2%”, and setting monetary conditions appropriately, this isn’t the cause of any big disjoint in the dollar from its “fundamental value” (unless you believe the RBNZ is setting policy too tight, or other economies are setting it too loosely, for their mandate – which would imply low inflation here, or high inflation overseas).

INE:  But you are missing the point.  It is obvious that the RBNZ is setting an interest rate that is too high for the economy, just to meet its inflation mandate!

N:  This is where I think you are a bit confused on what the RBNZ is doing.  By meeting its inflation mandate, it is partially setting the opportunity cost for bank lending (the OCR), which helps to guide the interest rate towards its fundamental level.  However, the fundamental interest rate isn’t set by the Reserve Bank, it depends on savings and investment in the economy, the expected rate of return, the time preference of individuals, the stance of fiscal policy, and the structure of the tax system (and its impact on rates of return).  If non-inflation accelerating real interest rates in NZ are higher it has nothing to do with the Reserve Bank – and it has everything to do with these issues, which are influenced by government policy, industrial policy, competition policy, and the efficiency of financial markets.

INE:  But, the Reserve Bank sets interest rates and the exchange rate!

N:  Not really.  They are “managing our fiat currency” in such a way that the real value of a dollar erodes at a constant and predictable rate – this increases certainty for households and businesses, and helps them interpret what changes in market prices mean.  They also try to limit the variability output in the general economy in the short term, by taking advantage of aspects such as “money illusion” through the way they change the OCR (although, things get a bit more complicated as we add in expectations and time consistency – these things can be left to the side for now 🙂 ).  However, none of this has to do with any long-term, persistent, shifts in the New Zealand economy.  In so far as we are concerned about the exchange rate being “too high” for a long period of time, and the current account deficit being “persistently large”, this is the result of the fundamental savings-investment issues in the New Zealand economy.

INE:  But if the RBNZ cut the OCR, and interest rates fell, and the dollar fell, we’d be “more competitive”.

N:  Then prices, including costs, would rise.  Within a few years, our exporters would be just as uncompetitive at the new “lower” exchange rate – implying that these persistent imbalances would simply return.

INE:  But exporters are complaining about the exchange rate.

N:  Exporters are complaining about the low rate of return – the exchange rate is a symptom of this not the cause.

INE:  So you are saying that these issues have nothing to do with inflation targeting, and even the impact of the exchange rate itself tends to be overstated.

N:  Yes.

INE:  I don’t believe you.

N:  That’s a pity.

5 replies
  1. Paul Walker
    Paul Walker says:

    “the dollar is too high”

    What does “too high’ mean? When is any price “too high”?

    • Matt Nolan
      Matt Nolan says:

      Indeed – that is the sort of issue I’m getting to when I state that we should ask “why”.

      I like to start with “why” as it forces us to frame the issue and really look at it – then we can sit back, and look at what it all means.

  2. jamesz
    jamesz says:

    I love this but the final exchange is highly unrealistic: when did you ever bow out of an argument about economics, Matt?

  3. Matt Nolan
    Matt Nolan says:

    Via Phil Sage who the site was being mean too and not letting their comment up! (http://sagenz.typepad.com/about.html)

    NIM: China
    has been suppressing its foreign currency prices for years in order to boost
    exports at a an artificially low price.
    It has achieved this by using its autocratic might to keep wages
    suppressed and industrial credit freely available. America, Europe and Japan are busy printing
    money to prop up their economies and/or inflate away the value of their
    external debts built up in the boom times.
    This has the effect of driving their government interest rates close to
    zero. There are also doubts about the stability
    of the Euro. International capital
    owners look for places to put their capital where it can earn a real return. New Zealand is economically and provincially
    stable and has proved on a long period that its Treasury bonds offer a 2% risk
    premium that is mostly unjustified.

    All of these
    factors increase the amount of foreign currency that is moving to New Zealand. Simple Supply and demand bids up the price of
    NZF:FXC. Slowly but steadily all that
    excess capital in the country looks for risk free homes and the country is sold
    to foreigners. All other things being equal an NZ business starts at a
    disadvantage to his foreign competitor.
    And all other things are very definitely not equal. New Zealand should attempt to sterilise the
    impact of this foreign manipulation in order to compete on closer to a level
    playing field. Switzerland has introduced
    a currency floor and will print money if the rate goes below this floor.

    Matt: I will
    respond with something other than repeating a classical economic theory that
    fails with the real world situation you highlighted….

    NIM: The
    inflation argument does not hold in the short term because austerity means
    companies cannot increase prices and workers are scared to ask for a payrise in
    case they lose their jobs. That has been great for overseas corporates
    profitability. . NZ has not shared because its exchange rate is
    artificially over valued.

    Matt: …

    NIM: For a
    number of decades now the low skilled worker has not really had a pay rise
    because their jobs have been replaced by cheaper Asian, Eastern European and
    Central American workers. The welfare
    net has seemed more comfortable than getting educated.

    In the
    longer term the impact of printing all that money may have an inflationary
    impact. In the short term bank
    de-leveraging, worker job fears and technology are having an offsetting impact.

    There is
    also a decent argument that the statistics are unable to keep up with the
    complexity of the change around us. For
    some years an august authority such as UK ONS has faithfully reported RPI at
    0.8% p.a above CPI and GDP deflator. This
    is not logically possible.

    In the
    really long run Asian wages will increase but technology will replace much
    unskilled labour. It is apparent that the statistics are not really
    good enough to keep up with the impact of the massive increases in energy
    efficiency. A more appropriate measure
    may be Globally Marketable Output. This report
    is worth reading for the concept of GMO. I dont agree
    with the conclusions but the theory and some of the ideas are pretty
    interesting. The facts on energy from p64 are worth reading alone.

    hmmm. I need a cup of coffee and a bit
    of time to digest that.

    • Matt Nolan
      Matt Nolan says:

      Here is me replying as me.

      Phil, I think you are underestimating both the economic framework and how I’ve looked at the issue here.

      Where you say:

      “Matt: I will respond with something other than repeating a classical economic theory that fails with the real world situation you highlighted”

      You are wrong about economics – we have discussed these issues in detail, and monetary policy is still the area where we have the most empirical success! Firstly, when it comes to China I have written about the currency manipulation heavily in the past – it is a mixture of excess savings in China due to both central management and their messed up population demographics, and subsidies for exporters.

      As a result of this, during the first decade of the century, you had China essentially willing to pay for part of what they were selling us, and give us very low interest rates to do so. This is completely consistent with the “excess savings hypothesis” that Bernanke had talked about the entire time.

      All the other countries you’ve mentioned have intervened more recently to reach an inflation target – the exact point I made in the post. Remember the combination of inflation outcomes and expectations and the nominal dollar tell us something very real about what is going on in the economy – it is this “third set” of factors that is all important. For example, if we have a cold and a runny nose, we don’t go to cut off our nose – it is a signal of the underlying problem.

      Regarding your next points – you do realise that economists spend a lot of time analysing wages and inflation. In NZ, low skilled workers HAVE seen significant pay increases, and if “money printing was going to cause mass inflation” we would see it in the inflation expectations markets … which we don’t.

      Also we do spend a long time looking at inflation indicies. For example, the CPI, RPI, and GDP deflator are completely different concepts measuring different things – CPI is a fixed bundle of goods, RPI is a different bundle including interest expenses, and the GDP deflator changes with the composition of consumption.

      I completely agree – every economist completely agrees – that the price level is biased by technology change! But that is why we put in estimates of this change, use a positive inflation range instead of a zero point target, and use statistical techniques and filters to find real “inflation” (the comovement in prices – such to find the component that is unrelated to real changes in demand and supply).

      “In the really long run Asian wages will increase but technology will replace much unskilled labour.”

      This isn’t necessarily fact, but it actually sounds a lot like what I just wrote on last week.


      I would note the point of this argument is to put forward a “reasonable interpretation” of what the other group has said about the issue, and the conversations you have had with them – the version of me in this comment doesn’t say very much, appears to have forgotten everything they’ve said in the past, and doesn’t make any of the obvious points about where the facts your narrative is relying on are a tad misleading.

      If you disagree with economists because that is your counterfactual view of them, then I’m sorry I haven’t been more engaging. Hopefully I can do future posts that will be clearer.

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