Those Who Forget History, Are Probably Historians

There are hardly any economists or economic historians who have contributed more to our understanding of the role of international finance in the Great Depression than Barry Eichengreen and Peter Temin. [1] So it’s disappointing to see them so strenuously refusing to learn from that history.

They start by correctly observing that the fatal flaw of the gold standard was the “asymmetry between countries with balance-of-payments deficits and surpluses. There was a penalty for running out of reserves .. but no penalty for accumulating gold.” Thus the structural tendency toward deflation in the gold standard era, and the instability of the system once workers recognized that lower wages for “sound money” wasn’t such a great deal. If Temin and Eichengreen want to draw a parallel with the Euro system today, well, I’m not sure I agree, but it’s an avenue worth pursuing. But as they want to apply it, to the US and China, it’s unambiguously wrong, as economics and as history.

“The point,” say Temin and Eichengreen, “is not to let deficit countries off the hook.” Barry, Peter — read your books! Letting the deficit countries off the hook is exactly the point. If there’s one lesson in Lessons from the Great Depression, it’s that no practical response to the crisis was possible until the idea that a trade deficit represented a kind of moral failing was abandoned. The whole point, first, of leaving the gold standard, and later, of the Bretton Woods institutions, was to free deficit countries from the obligation to “live within their means” by curtailing domestic investment and consumption.

Keynes couldn’t have been clearer on this. The goal of postwar monetary reform, he wrote, was “A system which would maintain balance of payments equilibrium without trade discrimination but also without forcing unemployment .. on deficit countries,” [2] in other words, a system in which governments’ efforts to pursue full employment was not constrained by the balance of payments. We needn’t take Keynes as holy writ, but if we’re going to analyze current arrangements in light of his writings in the 1940s, as Temin and Eichengreen claim to, we have to be clear about what he was aiming for.

One would expect, then, that they would go on to show how “global imbalances” are constraining national efforts to pursue full employment. But they don’t even try. Instead, they offer ambiguous phrases whose vagueness is a sign, perhaps, of a bad conscience: Keynes “wanted measures to deal with chronic surplus countries.” What kind of surpluses, exactly? and deal with how?

The beginning of wisdom here is the to recognize the distinction between the balance of payments and the current account. Keynes was concerned with the former, not the latter. Keynes didn’t care if some countries ran trade surpluses or deficits, temporarily or persistently; what he cared about was that these imbalances did not interfere with other countries’ freedom “to pursue full employment and progressive social policies.” In other words, current account imbalances were not a problem as long as the financial flows to finance them were guaranteed.

“Creditor adjustment” is rightly stressed by Eichengreen and Temin as a central feature of Keynes’ vision of postwar monetary arrangements, but they seem to have forgotten what it meant. It didn’t mean no one could run a trade surplus, it just meant that the surplus countries would be obliged to lend to the deficit ones as much as it took to finance the trade imbalances. As Keynes’ follower Roy Harrod put it,”The most important requirement [is] to get the United States committed to creditor adjustment. …. Creditor adjustment could be secured most simply by an agreement that the creditor would always accept cheques from the deficit countries in full discharge of their debts. … So long as their credit position cannot cause pressure elsewhere, there is no harm in allowing a further accumulation.” All of Keynes’ proposals at Bretton Woods were oriented toward committing the countries with surpluses to lend, at concessionary rates if necessary, to the deficit ones.

China today accepts American checks in full discharge of our debts; they don’t demand payment in gold. The Chinese surplus isn’t putting upward pressure on US interest rates, or constraining public spending. All Keynes ever wanted was for all surplus countries to be like China.

“Sixty-plus years later, we seem to have forgotten Keynes’ point,” Eichengreen and Temin conclude. True that.

[1] The strangely forgotten Robert Triffin is one.

[2] The historical material in this post post, including all quotes, is drawn from chapters 6 and 9 of the third volume of Robert Skidelsky’s biography of Keynes.

Some Thoughts on the Euro

[I just posted this in response to a query on the UMass-Amherst economics department listserv. I reckon it might as well double as content for the blog.]

i’ve heard some people say that it would be best to keep the euro and the dollar at a 1:1 exchange rate. why would this be good? why might it be bad?

The Euro is currently at about $1.22. The last time it was significantly lower than this was in late 2003. The last time it was as low as $1.00 was in October 2002. So what you are hearing are proposals for a substantial depreciation of the Euro.

Why do people want this? I don’t think it’s any more complicated than (1) Europe, like the US, continues to see employment and output held down by inadequate aggregate demand, (2) political elites in Europe (especially Germany) are resistant to any effort to boost either public or private consumption, leaving exports as the only potential source of increased demand, and (3) net exports are assumed to respond to relative prices, and relative prices are assumed to move with exchange rates.

Folks like Dean Baker and Paul Krugman have been making similar arguments for the US — that given the lack of political support for further expansion of public spending, getting back to full employment will require a big improvement in the current account, meaning a big depreciation of the dollar. (Krugman tends to express this — unhelpfully IMO — in terms of Chinese “manipulation” of the yuan-dollar exchange rate, but the argument is the same.) Baker even gives the same figure you’re hearing — 20 percent — as an appropriate amount for the dollar to fall.


First, since the US and the Euro area are both so large in world trade, it might be hard for both currencies to depreciate simultaneously. This is less of a problem than you might think, since there’s surprisingly little direct trade between the US and Euroland — less than 20 percent of the exports of each go to the other. (The US sells more to Canada’s 33 million residents than to the Euro area’s 330 million.) But it’s still the case that if the Euro is to fall against the dollar while the dollar itself is depreciating, both would have to fall even more against third-country currencies, which might be harder to achieve, and more disruptive if it were.

Second, the two cases are not symmetric. The US is starting from a position of big current account deficits, which have to be financed by large financial inflows which, arguably, contributed to the financial crisis. There is a plausible argument that, given the lack of international institutions to regulate capital flows, stable growth is more likely if countries remain in rough current account balance. So — by this logic — an improvement in the US current account wouldn’t just increase demand in the US, it would help prevent future financial crises. The Euro area, on the other hand, is in rough balance already — since 1999, the Euro area has run a current account deficit averaging just 0.2 percent of GDP. So an improvement in the Euro-area current account would mean a movement toward big surpluses, i.e. toward larger trade imbalances that would have to be financed by larger international capital flows. In other words, it would require the Euro area to assume a (larger) net creditor position towards its trade partners, i.e. to recapitulate the dynamic between Germany and Greece, Spain, etc. earlier in this decade. Perhaps the folks you are talking to feel that was a big success?

Third, leaving aside the desirability of an improvement in the Euro-area current account, there’s a question of how effective a tool Euro depreciation would actually be to realize it. I don’t have any estimates of exchange-rate elasticity for the Euro area handy. But for the US, estimates of import elasticity generally fall between 0.1 and 0.3 and export elasticity between 0.6 and 0.8, meaning that the Marshall-Lerner-Robinson condition is satisfied weakly at best, and a depreciation would produce little or no improvement in the trade balance. Of course the more favorable starting trade balance works in Europe’s favor here, making it more likely that a depreciation would improve the current account. But in the absence of concrete evidence for reasonably high exchange-rate elasticities, one shouldn’t just assume — as too many people do — that exchange rate changes reliably produce the “right” effect on trade.

So those are some arguments against. A few more issues.

One, why parity specifically? The argument one sometimes hears is that the goal should be PPP parity. Personally, I don’t buy that either — it assumes there are no systematic divergences in the ratio of tradable and non-tradable prices between the US and Euroland — but at least it has some principled basis. The International Comparison Program of the World Bank, which is the main source of PPP estimates, gives a range from $1.08 to the Euro for Germany to $1.25 Euro to the dollar for Spain (price levels vary across the Euro area) but there’s no major Euro country for which the PPP Euro is as weak as $1.00, let alone for the area as a whole. So 1 euro = 1 dollar looks like undervaluation by any standard.

Two, is this an argument mainly about the level of the Euro, or is it also about the desirability of fixing the Euro-dollar exchange rate? There’s a huge literature on fixed vs. floating exchange rates, which I’m not going to try to summarize here.

Finally, there’s the question of how a lower Euro would actually be achieved. For various reasons, I suspect the tool might be lower short-term interest rates, rather than (or in addition to) direct foreign-exchange market intervention. In that case, a policy of weakening the Euro might in effect be an excuse for the ECB to take a more expansionary stance than it is willing to do on domestic grounds. Ten years ago, the ECB’s attempts to strengthen the Euro were defeated by the perception that the higher interest rates involved would reduce European growth. (See here.) The opposite could happen now — lower interest rates, by increasing domestic demand and growth prospects, could increase imports and foreign investment into the Euro area, resulting in the current account moving more towards deficit rather than surplus — the opposite of the intended result. Which, ironically, would be the one good argument in favor of the policy.

A Difference of Perspective

So I’m reading Menzie Chinn’s helpful primer on different ways of calculating real effective exchange rates. And it’s got a bunch of pictures in it like this one, of various real exchange rates between the Indonesian rupiah and the dollar:

What do we see here? Well, when the dollar got strong in the early 1980s, the rupiah fell against it in real terms defined relative to export prices, but much less so in terms of domestic goods as measured by the CPI. Whereas when the rupiah fell in the Asian crisis, the real exchange rate fell whether you measured it by CPI or by export prices, albeit more by the latter. In other words, the strong dollar of the ’80s did not substantially increase American incomes relative to Indonesian, but the fall in the Rupiah in the ’90s did reduce Indonesian incomes relative to American. Interesting!

So when Chinn writes, “there are a number of interesting stylized facts to be gleaned from these figures,” I expect him to say something about these movements. But not a word! Instead, his discussion is all about the CPI-deflated series’ “more pronounced upward trend (or a less pronounced downward trend)” over the long run(the parenthetical is a nice concession to reality). “This pattern is often explained as the outcome of the Balassa-Samuelson model, wherein more-rapid productivity growth in the tradable sector than in the nontradable sector results in a rise in the relative price of nontradables.” So what Chinn sees in these figures is the rather dubious long-run pattern predicted by theory; he doesn’t notice the exciting ups and downs at all. And he’s one of the good ones.

“When the storm is long past, the ocean is calm again…”

EDIT: Now that I think about it, I’ve got the story of the ’80s wrong. The rupiah was pegged at that point, so when the dollar rose, the rupiah rose with it (apart from the two devaluations visible as downward spikes in the graph.) The decline in the export-price deflated series represents Indonesian exporters cutting their own-currency prices to remain competitive in world markets, something that US exporters, for various reasons, did not do. The larger point still holds.

Another One for the Pessimists

Elasticity pessimists, that is.

Following up on the long post on Krugman and China, here’s some interesting evidence on the non-responsiveness of trade flows to exchange rates. It’s a study of what happens to online book prices in the US and Canada when the exchange rate between the two countries change. In theory, when the exchange rate changes, online retailers should adjust local-currency prices so a given book costs the same in both countries; if they don’t, book buyers should buy from the country where prices are cheaper. As the authors say, online bookselling is “an activity where trade barriers are minimal, information is cheaply available and products are homogenous. If pervasive cross-border arbitrage was ever going to arise, it would be in sectors like online book retailing.” [1]

And if pigs were ever going to fly, it would be the most svelte and limber ones.

In fact, local-currency book prices don’t respond to exchange rate changes, so you get big differences in the price of books bought from, say, and (Yes, this takes shipping costs into account.) But people blithely go on on buying from their own country’s site: “The fact that books in Canada become cheaper following an appreciation of the US dollar should be reflected in higher sales for Canadian retailers. Using sales rankings as proxies for quantities, we find no evidence supporting such behaviour.”

Since they are real economists, they conclude that exchange rate movements need to be bigger and more persistent to affect trade. But if you’re some kind of Keynesian freak, you might take this as further evidence that exchange rates just aren’t that important to the current account balance.

[1] Besides these factors, online bookselling is also unusual in that the goods are bought directly from the exporting country. Most traded goods and services are sold, and therefore priced, in the importing country. So there’s the additional step of pass-through to prices further reducing the impact of exchange rates.