A James Alexander post
In a response to Paul Krugman’s continuing puzzlement over the Brexit shock, Brad DeLong tries to claim Krugman is making some sort of basic error. It i is not easy to spot what it is but he does commit one himself. He thinks that the main channels for the working of a devaluation are greater exports and a rebound in (?overseas) investment once the currency has dropped far enough and make UK costs internationally attractive.
As I tried to show in my previous post, the main channel for devaluation is domestic not international. The worsening of the value of the pound stimulates nominal demand in the UK, so long as the central bank does not fight it with monetary tightening – aka “defending the currency”. The domestic currency is less valuable, in terms of the goods and services it will buy and this is a good thing. It will prompt people to spend money more quickly, the hot potato effect” in action.
This faster circulation of money, higher velocity, will increase Aggregate Demand and be a successful fightback against the potential Aggregate Supply shock. The market’s immediate response was a mix of political and economic fears, while technically trying to factor the most likely near term impact of leaving the EU – like lower FDI, reduction in output via moving production to EU ex-UK, and indirectly less UK labor demanded, etc.
The rise in Aggregate Demand may not mean in real terms the UK economy will not lose out from the potential Aggregate Supply shock, but it will prevent the potential AS shock from turning into a damaging recession. It will also allow the government time to negotiate new trade relationships with the EU and others and for the real economy to then respond to the new arrangements – which may turn out better than the worst case assumed by dazed (or is it crazed) Europhile doom-merchants , or better than now as Brexiteer economists have modelled.
The devaluation channel is not “more exports” or “more foreign investment”. This is naive despite a widespread belief of much of the financial commentariat that it is the main channel. I would have supposed that someone as knowingly iconoclastic as Brad DeLong would not have fallen into this sort of trap.
Brad DeLong may be making a second huge error, but it is hard to tell. He has a chart in the post that shows UK Gilt yields collapsing after 2008. He doesn’t refer to it in the text but does claim 2016 is different from 1992, when the UK left the Exchange Rate Mechanism and saw a mild potential AS shock swamped by massive monetary easing as the GBP devalued.
I think he may be claiming that because Gilt yields are already on the floor there can be no more easing. If so, then he is making a very common error that associates low interest rates with monetary easing. Low rates are a sign that monetary policy is or has been tight, high rates that monetary policy is or has been easy.