"It is easy to confuse what is with what ought to be, especially when what is has worked out in your favor."
- Tyrion Lannister

"Lannister. Baratheon. Stark. Tyrell. They're all just spokes on a wheel. This one's on top, then that's ones on top and on and on it spins, crushing those on the ground. I'm not going to stop the wheel. I'm going to break the wheel."

- Daenerys Targaryen


"The Lord of Light wants his enemies burned. The Drowned God wants them drowned. Why are all the gods such vicious cunts? Where's the God of Tits and Wine?"

- Tyrion Lannister


"The common people pray for rain, healthy children, and a summer that never ends. It is no matter to them if the high lords play their game of thrones, so long as they are left in peace. They never are."

- Jorah Mormont


"These bad people are what I'm good at. Out talking them. Out thinking them."

- Tyrion Lannister


"What happened? I think fundamentals were trumped by mechanics and, to a lesser extent, by demographics."

- Michael Barone

"If you want to know what God thinks of money, just look at the people he gave it to."
- Dorothy Parker

Monday, March 16, 2015

Sumner on Krugman and Europe

For simplicity, suppose we started with US and eurozone interest rates being equal. After the monetary injection the eurozone rates are lower.  So the euro is expected to appreciate.  But in the long run it’s expected to be 10% lower.  That means the immediate effect of a monetary stimulus shock must be a more that 10% decline in the euro.  Dornbusch called this exchange rate overshooting.  The model is composed of 4 theories (QTM, PPP, IPT, liquidity effect.)  Most of us are not as adept at juggling 4 theoretical balls in the air at the same time as Krugman, so we struggle with the concept.  As for empirical evidence, these things are hard to test. I’d argue that each component is pretty well established, and that’s good enough (and I suspect Krugman would agree.)  In any case, it’s too beautiful a theory not to use once and a while.  Here’s Krugman:
So, can we say anything about how the recent move in the euro fits into this story? One way, I’d suggest, is to ask how much of the move can be explained by changes in the real interest differential with the United States. US real 10-year rates are about the same as they were in the spring of 2014; German real rates at similar maturities (which I use as the comparable safe asset) have fallen from about 0 to minus 0.9. If people expected the euro/dollar rate to return to long-term normal a decade from now, this would imply a 9 percent decline right now. 
What we actually see is almost three times that move, suggesting that the main driver here is the perception of permanent, or at any rate very long term European weakness. And that’s a situation in which Europe’s weakness will be largely shared with the rest of the world — Europe will have its fall cushioned by trade surpluses, but the rest of us will be dragged down by the counterpart deficits. 
Now, this is not how most analysts approach the problem. They make a forecast for the exchange rate, then run this through some set of trade elasticities to get the effects on trade and hence on GDP. Such estimates currently indicate that the dollar will be a moderate-sized drag on US recovery, but no more. What the economic logic says, however, is that if that’s really true, the dollar will just keep heading higher until the drag gets less moderate.
Krugman’s looking at real rates to abstract from inflation.  While the Dornbusch overshooting model does a nice job of explaining the recent dramatic plunge in the euro, the model also predicts that the real exchange rate is unaffected in the long run. But that’s because interest rates are unaffected in the long run.  Krugman’s readers don’t know this, but unless I’m mistaken he’s arguing that the recent fall in long-term interest rates in Europe is the income effect, not the liquidity effect.  I actually like that argument, but it’s not the way Keynesians usually look at changes in long-term rates occurring in close proximity to QE.  Most Keynesians would say the ECB is driving bond long term bond yields lower.

So Krugman’s arguing that the big fall in the expected 10-year future exchange rate reflects worsening prospects for long term European growth, not just monetary stimulus.  That argument makes sense to me.  But he’s also arguing that this increasing long-term pessimism occurred at almost exactly the same time that expectations of short-term growth became more optimistic.  That might be true, but I kinda doubt it. And yet I can’t think of a better explanation for the fall in the future expected value of the euro.

So I’ll file this under “unresolved problems.”

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