Brexit devaluation is monetary offset in action

A James Alexander post

I agree with Scott Sumner in his strong belief in the Efficient Market Hypothesis. The market is always right. But quite what it is “right” about is not always easy to tell. Sure, on central bank announcements the immediate market reaction is very telling. The market reaction is the policy, and this is not always what the central banks thinks is the policy.

The surprise Brexit vote did lead to some huge movements as markets opened on Friday 24th June and then more on Monday 27th after a weekend of follow-up news and reflection. But what were the markets signalling, especially the GBP devaluation and the large drops in the most domestically-oriented equities?

Scott Sumner wrote:

Brexit will reduce the foreign demand for British goods, services and assets. Since one needs pounds to buy British stuff, this reduces the value of the pound, as well as the quantity of exports. Think of it as a leftward shift in the demand for pounds, on an S&D diagram.

I am willing to admit less demand for pounds due to expected less FDI, as some global firms who based their EU businesses in the UK think of moving that production to inside the newly shrunk EU ex-UK. This is not a domestic demand shock directly as businesses would be choosing to produce less goods and services in the UK that were then exported.

Exports would also be expected to fall, further weakening demand for pounds, already weakened from less expected FDI.

The indirect effect is a demand shock for labour in the UK, that in turn reduces demand for goods and services within the UK.

UK workers are not less productive, there is just less demand for them. It is very hard to claim that the potentially lost UK export industries are more or less productive than average UK industry.

Other things being equal, less FDI, less exports and a potential, indirect, demand shock will shrink the size of the UK real economy. The drops of 10%-30% in some domestic-focused UK shares in particular sectors like commercial and residential real estate (British Land and Barret Developments), retail (Tesco and Marks & Spencer), banks (Lloyds Bank and Close Brothers) and media (Sky and ITV) illustrate this fear well.

However, care needs to be taken when looking at these sectors and judging the stock price falls. Property companies and banks are leveraged plays on the local economy, so that any local economy weakness gets magnified, sometimes greatly. Retail companies have been suffering from weak NGDP for years, as well as from the secular change to internet retailing, and so their equity prices may be particularly vulnerable to small changes in AD.

And care also needs to be taken not to assume the worst. Both the outcome of the negotiations with the EU and the eventual trade agreements with the Rest of the World will alter greatly these worst-case scenarios. In the absence of a government, fear and uncertainty get free reign but will dissipate over time, perhaps more quickly than many expected. if the latest news on Mrs May’s unopposed path to the top job is anything to go by.

Here comes the offset

But as Scott knows well a leftward shift in the demand curve for pounds is not like a shift in the demand curve for apples. A devaluation will lead to major monetary offset in the country experiencing the devaluation – even if these benefits are not immediately apparent – or understood by many commentators. The benefits will still accrue unless the devaluation is artificially prevented. So far the signs from the Bank of England are that it will be encouraged.

The current account may or may not improve following a devaluation as Chris Giles succinctly explained in the FT last week. He was echoing many macro experts. Unfortunately, Giles, like most economists and commentators who understand the subtleties of devaluation on trade deficits missed the bigger picture. The main benefit of a devaluation is something else.

In early 2014 in a discussion about Abenomics Scott re-posted a classic comment from the legendary Mark Sadowski. The punchline is very clear:

Devaluation improves a country’s trade balance only if the Marshall-Lerner condition on trade elasticities holds, and research shows that they’re not met in the majority of cases, either past or present:

That’s not to say that currency devaluation isn’t beneficial, of course it is, but the benefit flows primarily from increased domestic demand. 

Chris Giles does understand, and in fact warns in a follow-up  piece about higher inflation in the UK as a consequence of the devaluation and how it might hurt households:

In summary, Brexit has unleashed a different sort of currency depreciation, according to modern economics, one that is less likely to encourage domestic investment for exports, is more likely to raise inflation and will be more painful for hard-pressed families.

But it will drive up NGDP up, as domestic demand has to rise in nominal terms, and this, given wage and price stickiness, will drag up GDP in real terms too.

In fact, this rising nominal demand will be especially welcome in a UK economy starved  of nominal growth for the last 12 months. Something on which Giles and most of the UK macro-economic commentariat have been notably, not to say shamefully, silent.

Around the same time as the Sadowski re-post but on a different subject, Britmouse over at uneconomical also had an excellent post making a related point:

It is not that a[negative]productivity shock causes a rise in unemployment.  A productivity shock causes a tightening of monetary policy which causes a rise in unemployment.  

Brexit may cause a supply shock but there will only be a rise in unemployment if monetary policy is also tightened. If monetary policy is eased there will be moves within the economy from one job to another, but not an overall reduction in employment. That is the benefit of stable nominal growth, some people may experience low or no nominal wage growth but they will not be made unemployed.

Will the UK be poorer on leaving the EU? Maybe, but economies are quick to adjust as long as nominal growth is maintained at a suitable level. Unilateral free trade would also help as sagely proposed by the economists for Brexit.

Offset here, offset there, offset everywhere

A James Alexander post

I have been away on vacation. Unlike the BoE’s Kristin Forbes I haven’t come back with a homily about the need to wear suntan lotion as a good analogy for monetary policy. Walking along, or rather up and over, the Amalfi Coast did make me very much acquainted with concrete steps as well as the beautiful views.

The effort of walking up all those steps did set me thinking about monetary offset as my muscles wearied. Analogies of pushing water uphill also came to mind as I lugged several plastic bottles of water around. It made me think of my earlier matrix that tried to distinguish various economic states dependent on the stance of monetary and fiscal policy. While helpful, I think it was also somewhat misleading.

On another view, there is only monetary policy, defined as the value of money relative to real goods and services. All else is just tools: official short term policy rates, IOER, targeting or guidance, QE, fiscal policy.

JA Offset_1

Scott Sumner has been dogged in drawing attention to the fact of “monetary offset”, whereby the tool of expansionary fiscal policy is offset if the overarching policy tool is inflation targeting. Monetary policy will stay tight if the market believes the central bank thinks their inflation target is at risk under the expansionary fiscal policy. The riskiness of an expansionary fiscal policy is moot, but if the market believes the central bank is concerned then the policy will be offset.

Market Monetarists have gone further and shown how the targets morph into ceilings  with terribly depressing results on inflation, but unconcerning to the central bankers.

The theory of monetary offset can also apply to “monetary” tools themselves. The intended help given to an economy from low official interest rates can also offset by those, more important, inflation targets. Paying IOER offsets the impact of low official rates. QE will be offset by strict inflation targeting. Using the targets of “full employment” or “lack of slack”, ie the once discredited Philips Curve, will also offset the benefits of other monetary policy tools.

Formal models like to work with concrete things, like the actual level of official rates, the actual level of employment/unemployment, the targeted “inflation rate”, the actual amount of QE, the actual amount of deficit spending or the actual size of the debt. But all these actuals come into conflict,and can and do offset each other. In Brazil at the moment fiscal expansion is beginning to offset inflation targeting as Marcus Nunes  has recently shown. When that happens the monetary policy is effectively set to high or even hyper nominal growth, most of it or even all of it inflation.

So many tools, so many offsets actually leads to a kind of policy chaos

The big point here is that, more than ever, the monetary policy is whatever society (or the market or economic participants) believes it is, not what officials say it is. Central bank officials like to bang on about “credibility”, and in a way they are right. It is what the society believes about the central bankers’ goals that matters, that influences economic activity: spending, saving, working, investing.

JA Offset_2

If society believes they are poodles of an irresponsibly expansionist and corrupt government then we know what happens. If society believes they are, like today, prisoners to a bankrupt theory like the Philips Curve then the goals will be very unclear and society will grasp at whatever seems to be uppermost in the minds of those in charge. Hence. we see the constant and detailed parsing of every speech or interview given by the policy makers. It is a social position  that many seem to rather enjoy, and even milk for their own private benefit, especially once they’ve left office.

The tidy world chart is too formal. The real world is the tidy world but enveloped in a cloud of expectations about what the future holds for monetary policy, which tools will be pre-eminent and for how long. And this just serves to emphasise the central role of expectations in monetary policy, especially when the tools are so numerous and the policy is so vague.

Keep It Simple Stupid

Market Monetarists believe that the policy makers should go back to basics and simply target stable expectations for the growth rate for the nominal economy, or NGDP forecasts. It’s a highly prudent and responsible policy and very transparent, far more so than targeting inflation, “full” employment  or worse the output gap or “slack”.

The tools by which they choose to achieve that goal are not that relevant.  The central banks can then step out of the limelight and leave economics and politics to debates over micro-economics.

Strange “Coincidences” – “A graphic novel”

The graphics:

Graphic Novel

The takeaway:

When house prices peak and begin a gentle decline, real output “recedes” from its trend level.

When nominal spending (NGDP) detaches itself from trend real output worsens.

When nominal spending “tanks” real output follows suit, while house prices intensify the fall.

Through all this time, fiscal policy was expansionary (rising deficit).

“Coincidentally”, when fiscal policy ceases to be expansionary and becomes contractionary, real output starts on its slow “upward trek”. But, also “coincidentally”, that´s the time that nominal spending reverses direction and begins a “slow climb”.

The 2013 “fiscal cliff” does not change “trends”.

At the time of the “fiscal cliff”, Lord Skidelsky, proxying for many and Krugman in particular, wrote: “Fiscal contractions are not expansionary, period”.

As illustrated, you could also say: “Fiscal expansions are not expansionary, period”, or, “Fiscal contractions are not contractionary, period”!