Exchange Rate Behavior During the Great Recession ...

Exchange Rate Behavior During the Great Recession

Abstract: This paper offers a Post Keynesian/Institutionalist explanation of the dollar-euro exchange rate around and during the Great Recession. It is shown that, consistent with theory, the financial sector played a dominant role. Capital flows drove foreign exchange rates, causing both mis-determination and tremendous volatility, and the real economy was forced to adjust to the conditions they created (a line of causation, incidentally, precisely the opposite of that suggested by Neoclassicism). Among the paper’s conclusions are that currency price swings were clearly excessive, exchange rate fluctuations contributed to the sluggish recovery, and portfolio capital flows must be strictly controlled if these are to be avoided. Keywords: Exchange Rates, Great Recession, Institutionalist, Post Keynesian JEL Classification Codes: B52, E12, F31

John T. Harvey Professor of Economics Department of Economics Box 298510 Texas Christian University Fort Worth, Texas 76129 (817)257-7230 [email protected]

FINAL VERSION PUBLISHED AS: Harvey, J.T., 2012. Exchange Rate Behavior During the Great Recession. Journal of Economic Issues, 46(2), pp.313-322.

Most of the attention during the Great Recession–and rightfully so–has been on domestic issues: GDP growth, unemployment, bankruptcies, government budgets, etc. It is there that the impact has been the most striking and costly. At the same time, however, there have been dramatic events in the international economy. Since the onset of the recession, the dollar has both surged and tumbled, world trade has collapsed, and lines of credit have dried up. These have served to magnify the problems faced during the downturn and they continue to hinder recovery. This paper offers a Post Keynesian/Institutionalist (PK/I) explanation of events in the international monetary economy and particularly the dollar-euro currency market from 2006 through June 2011. It will be shown that, consistent with PK/I theory, the financial sector played a dominant role, driving capital flows and foreign exchange rates and forcing the real economy to adjust to the conditions it created. Note that such a line of causation from the monetary to the real side of the economy is precisely the opposite of that suggested by Neoclassicism. The paper proceeds as follows. In the next section, Neoclassical and PK/I theories of the international monetary economy are compared. Following that, the latter is used to explain the path of the dollar from 2006 through June 2011. The salient features of the episodes are then discussed and lessons drawn.

Post Keynesian/Institutionalist View of the International Monetary System Understanding what is unique about the PK/I view of the international monetary system requires first offering a quick review of the Neoclassical one. Consistent with their broader theory, they see the monetary side of the economy as at least long-run neutral. The real (and, more specifically, supply) side drives output and employment, while the financial sector passively 2

accommodates. The economy is self-regulating and automatically seeks the growth rate associated with the optimum allocation of resources and zero cyclical unemployment. As representative of this view, Christine Romer (former Chair of the Council of Economic Advisors for President Barack Obama) writes: Just as there is no regularity in the timing of business cycles, there is no reason why cycles have to occur at all. The prevailing view among economists is that there is a level of economic activity, often referred to as full employment, at which the economy could stay forever (Romer 2008). Within this context, financial markets may experience occasional shocks and bubbles, but the economy soon rights itself as the smart money takes over and punishes those who had driven asset prices to irrationally high levels. This general logic extends to the international economy, where the secondary role played by financial activities means that currency prices are assumed to be driven by trade flows not capital flows. Although the latter far outweigh the former, they are viewed as epiphenomenal. They arise only as a means of financing trade flows, which they do (as suggested above) obediently and passively. Because of this, exchange rates are generally expected to adjust slowly and smoothly and in direct response to trade imbalances: currencies of nations with trade deficits experience deprecation, and vice versa. This represents one of the many self-correcting mechanisms that Neoclassicals believe characterize the free-market system. Mainstream economists do not totally ignore the role of financial capital in the international economy. Indeed, it would be terribly difficult for them to have done so over the last several years. However, such explanations tend to be ad hoc and at odds with the core concepts described above. 3

This is not the case in PK/I economics. To begin, they believe that the long run is simply the accumulation of short runs. The past is qualitatively important and cannot be ignored because it may set us onto new growth paths. In addition, they argue that the existence of fundamental uncertainty and the fact that production takes time makes the financial sector much more important than as portrayed in the Neoclassical model. Funding, for example, is far from automatic: ...banks hold the key position in the transition from a lower to a higher scale of activity. If they refuse to relax, the growing congestion of the short-term loan market or of the new issue market, as the case may be, will inhibit the improvement, no matter how thrifty the public purpose to be out of their future incomes. On the other hand, there will always be exactly enough ex post saving to take up the ex post investment and so release the finance which the latter had been previously employing. The investment market can become congested through shortage of cash. It can never become congested through shortage of saving. This is the most fundamental of my conclusions within this field (Keynes 1937b, 668-9). In the PK/I view, money is neutral in neither the short or long run and capitalist economies are prone to systemic crisis and less-than-full-employment equilibrium. One of the consequences of this approach is that exchange rates are modeled as a function of capital flows. Currency prices move as international investors adjust their portfolios, which they do in response to actual and expected financial rates of return. These expectations are considered to be a central and causal factor in the PK/I view and are a function of agents’ mental model, or their internal representation of the workings of the real world (Harvey 2008 and 2009). 4

While many factors play a role therein, key in the post-Bretton Woods era have been actual and expected interest-rate differentials and relative national growth rates. The former are important because they offers a relatively predictable and often low-risk rates of return, while the latter is thought by market participants to be correlated with higher asset prices and future rates of interest. Within this context, agents typically maintain two general sets of expectations, a shortterm and a medium-term. The latter takes one of three states, bullish, bearish, or neutral with respect to a currency, and is best understood as a lens through which agents view and interpret information filtered through the mental model. If the medium-term expectational bias were bullish on the dollar, for example, pro-dollar information would be magnified and anti-dollar news and events downplayed or even completely dismissed. Analogously, if the medium-term bias were bearish on the dollar, pro-dollar factors in the mental model would be diminished and anti ones reinforced. Neutral means no particular bias is held in either direction. These forecasts (both short- and medium-term), because of fundamental uncertainty and the various psychological factors cited by Keynes and his followers, are “subject to sudden and violent changes.” (Keynes 1937a, 214-5). Hence, it would not be surprising to exchange rates exhibit short-term volatility and wide swings over the long term. The PK/I view thus describes an international monetary system dominated by autonomous and potentially unstable financial capital flows. The latter occur as agents alter their portfolios of assets, which they do based on forecasts derived from their mental model of the workings of the international economy. The most important factors will be actual and expected rates of interest and national growth rates, but many other inputs are also considered by investors. The actual weight of news and information is invariably affected by the general bias held with respect to a 5

currency, or the market’s medium-term expectations.

The Dollar and the Great Recession The question is, which characterization better describes the international monetary economy during the Great Recession? Was it marked by steady currency-price adjustment in response to trade imbalances in an atmosphere of rational market correction and return to fullemployment? Or did we witness volatile exchange rate movements driven by capital flows that followed interest- and growth-rate differentials and other financial-market indicators? Space limitations prevent an in-depth analysis, but the quick answer, as will be illustrated below, is the latter. From 2006 through the midpoint of 2011, the dollar collapsed three times and recovered twice and swung over a far wider range than would be suggested by fundamentals, particularly the trade balance (which would have indicated a constant dollar depreciation throughout the entire period–indeed, since early 1991!). At the same time, that volatility and uncertainty led trade flows to collapse as finance–far from a passively accommodating force–dried up. As a consequence, world banks were forced to take extraordinary measures to meet market demands for liquidity. All this is chronicled below (drawn, unless otherwise indicated, from the very detailed accounts in the Federal Reserve Bank of New York’s “Treasury and Federal Reserve Foreign Exchange Operations”). In order to offer perspective, this study starts in January 2006, almost two years before the official beginning of the recession (December 2007) and roughly fourteen months before the first major signals of the subprime crisis. Figure 1 shows the most widely traded exchange in the world, the dollar-euro, from 2006 through June 2011. The dollar’s path is divided into five 6

periods: Pre-Recession Collapse, Dollar Shortage, Post-Recession Collapse, Greek Debt Recovery, and Double Dip Decline.

Figure 1: The dollar and the Great Recession (source: Federal Reserve Bank of St. Louis and Economagic.com). Pre-Recession Collapse: January 2006-March 2008 The Pre-Recession Collapse (which actually includes the first few months of the Great Recession; the latter was officially dated from December 2007 to June 2009) lasted from January 2006 to March 2008. The dollar rose over most of 2005 due to a pro-dollar medium-term bias and a positive interest-rate differential (the latter often serves as an anchor to overall movements and a major focus for the formation of medium-term expectations); however, negative expectations regarding the latter had been accumulating. These soon became reality, starting a dollar slide in 2006. The medium-term dollar bias followed and became bearish. As a consequence, seemingly innocuous G7 statements in April (calling for flexible exchange rates in 7

emerging markets) were viewed as approval for the dollar’s depreciation. This was denied, but to no avail as market participants continued to divest themselves of dollar assets. Thus, the dollar was already falling before the subprime crisis proper hit due primarily to a closing interest rate differential and a consequent negative overall bias towards the dollar. There was a slight recovery early in 2007, but slow growth expectations soon took over and bad news about the housing market started filtering in. The latter really began to accumulate in March of 2007, by which time “At least 25 subprime lenders, which issue mortgages to borrowers with poor credit histories, (had) exited the business, declared bankruptcy, announced significant losses, or put themselves up for sale” (Der Hovanesian and Goldstein 2007). The average S&P closing price fell by almost seven per cent that month and the dollar lost 1.27% against the euro. Bankruptcies continued throughout the year and the dollar-euro interest rate differential, which had been in favor of the US currency, continued to close. These factors combined to see the dollar fall just over 12% against the euro from January to December. This continued into the first quarter of 2008, when there was a very steep decline as negative data accumulated and financial sector losses continued. As agents’ confidence in their ability to forecast the volatile market decreased, they retreated from speculative positions and the dollar finally stabilized. It did so at almost half of its value (vis a vis the euro) from eight years earlier!

Dollar Shortage: April 2008-February 2009 This ended the Pre-Recession Collapse and, despite the official onset on recession in December 2007, most of 2008 actually saw the dollar make significant gains against the euro. This was despite a large and growing trade deficit (something that should lead to deprecation 8

according to Neoclassical theory) and was a function of a distinctly monetary phenomenon: the collapse of the financial sector. This led to a serious shortage of dollar credit as surviving financial institutions became extremely risk averse, US businesses brought cash back home to cover potential losses, and market participants in general moved towards liquidity and quality (the latter, despite the crisis, still implying the dollar; Fratzscher 2009; McCauley and McGuire 2009). Meanwhile, the Federal Reserve set up swap agreements with numerous foreign central banks, including in particular those of Switzerland and the European Union. These lines were extended several times throughout the year and demand for dollars became so acute that the month of the Lehman Brothers collapse (September) actually witnessed a dollar appreciation (despite the sharp dip in the immediate aftermath).

Post-Recession Collapse: March 2009-November 2009 There had been bad news for dollar all along, but the market had been anti-euro to an even greater extent. This changed in March, when a) the general opinion was that European efforts to stabilize financial markets appeared to be more promising, b) market participants believed that economic indicators in the US continued to look extremely negative, and c) agents unwound their previously risk-averse, dollar-heavy positions. Indeed, because of the last item, some otherwisepositive actions by the Federal Reserve (e.g., an expansion of their holdings of mortgage-backed securities) actually led to dollar depreciations because they lowered market fears. This continued through the rest of the period, with the dollar falling as investors became increasingly convinced that the international financial market–even that in the US–was stabilizing.

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Greek Debt Recovery: December 2009- June 2010 In December, however, the market decided that the relative growth differential now favored in the US. In addition, while euro interest rates were still higher, the fact that the gap had closed over 2009 began to have an effect. Agents continued to view US growth potential in more positive light than the euro zone’s until mid year, particularly as the situation with Greek (and, to a lesser extent, Portuguese and Irish) debt dominated the headlines. This did not end until June, when a series of releases suggested that the US was not as strong as previously thought and the interest-rate differential swung against the dollar.

Double Dip Decline: July 2010-June 2011 US data continued to look weak compared to Europe and the interest-rate differential turned increasingly against the dollar throughout the period. Plus, there was the suggestion of further monetary easing by the Federal Reserve. There was a brief rebound in late 2010 as US growth data were better than expected and there were renewed concerns regarding some indebted EU countries, but overall the dollar fell by almost 18% versus the euro over this last period.

Discussion A number of things are clear from the above narrative. First, there appears to be far more evidence for the PK/I version of events than the Neoclassical one. There is no sign of a slow, steady adjustment to trade imbalances. Instead, we witness rapid and decisive reactions to financial market conditions. Currency prices are clearly portfolio asset prices. Second, the degree of currency volatility was most certainly excessive. Consider Table 1, 10

showing the dollar appreciations and deprecations over the five and one-half years studied. The smallest movement was a 16% rise in the dollar over the seven months of the Greek Debt Recovery! Such a rate of price inflation would most certainly not have been tolerated, and yet for certain sectors in the effected economies the impact was the same (during the oil crises of the 1970s and 1980s, U.S. annual inflation never reached 14%). We only accept this because we have become so jaded. It is impossible to justify the numbers on Table 1 as being a true reflection of the fluctuating values of U.S. and European goods and services or physical investments.

Table 1: Summary dollar movements from 2006 through June 2011. Period

$-euro movement

Pre-Recession Collapse: January 2006-March 2008 (27 months)

28% dollar depreciation

Dollar Shortage: April 2008-February 2009 (11 months)

18% dollar appreciation

Post-Recession Collapse: March-November 2009 (9 months)


Greek Debt Recovery: December 2009- June 2010 (7 months)

16% dollar appreciation

Double Dip Decline: July 2010-June 2011 (12 months)


And these excessive fluctuations most certainly had an impact. The real sector, that directly responsible for creating output and employment, was forced to adjust to the volatile and "mis-determined" (Harvey 2008, 124) prices set by the financial side. Currency price fluctuations were not the only factor, but the fact that world trade has been so sluggish to recover is related to these tremendous swings (Chor and Manova 2010; Yousefi 2010). Where these movements somehow justified on efficiency grounds, this would be acceptable. In fact, however, they were a result of the precarious and less-than-rational balance between uncertainty and animal spirits as manifested in agents’ mental model. There was no benefit to this cost. 11

Conclusions Most of the salient features of the Great Recession can be understood focusing entirely on domestic issues. It resulted from the financialization of the US economy, a drastic shift in income distribution, Minskyian financial fragility, and a Keynes-style business cycle. There are many lessons to be learned from these events and it is appropriate that most of the focus of scholarly research has been on them. But circumstances in the international economy were also noteworthy and provide an excellent, if terribly costly, example of what is wrong with our exchange rate system. The answer is simple and one that has been repeated time and again by PK/I economists: the impact of financial capital flows must be severely limited. Just as in the domestic market for financial assets, the excessively short-term time horizons of market participants means that otherwise-ephemeral factors exert a decisive influence on exchange rates. The price is paid by those without a seat at the casino: importers, exporters, consumers, and those undertaking direct investment–all activities much more closely related to the generation of output and employment. This is hardly a new insight. Indeed, during the Bretton Woods conference Keynes argued that nations must have, “Not merely as a feature of the transition, but as a permanent arrangement...the right to control all capital movements” (cited by Bryant 1987, 61-62; above quote from Krause 1991, 64). The experience of the Great Recession has not in any way diminished the relevance of his almost seventy-year old admonition. It has, in fact, done quite the opposite.

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