In his last press conference Mario Draghi said that the ECB was ready for negative deposit rates if necessary. His comments led to several European bankers rejecting this as a possibility (here and here). The comments of the Deutsche Bank and Commerzbank CEOs reflect on either their ignorance of how monetary policy works or their fighting against an ECB action that could make their lives harder (and their profits lower).
Martin Blessing from Commerzbank argues that "too much cheap credit could lead to future crises" and he concludes that he does not know "how too much cheap liquidity can solve a problem that was created by too much cheap liquidity." This argument has now been wrongly used for 5 years, I thought that by now we would have learned that this is the wrong analogy.
Fischen from Deutsche Bank complains that setting negative interest rates on deposits at the ECB would be like "penalizing banks". And this "will later be felt in a painful manner so that's what I've been warning about" (a threat?). This is the usual argument that banks are so important that you cannot do anything that annoys them. But what if negative interest rates are the right equilibrium value? In what way are we penalizing banks? Banks can go and invest their funds somewhere else if they find that this is not a competitive rate. In addition, it is not uncommon to have these CEOs arguing that what the Euro zone needs (in particular countries in the periphery) is a large reduction in wages. I guess this is fine. "Penalizing" workers is ok because they do not pose any systemic risk to the economy as a whole.
Antonio Fatás
Sunday, November 24, 2013
Wednesday, November 20, 2013
Saving glut or investment dearth?
Martin Wolf at the Financial Times argues that the future of the world economy, in particular that of advanced economies, looks sluggish because investment rates have displayed a downward trend over recent years, even before the financial crisis started. I made similar points in my blog post yesterday, let me add some evidence to that story.
It is a fact that since the mid 1990s interest rates in the world started a downward trend. This trend was explained by Ben Bernanke in his March 2005 speech
“To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain the relatively low level of long-term real interest rates in the world today”
This can easily be represented in a standard demand and supply chart for the global market for funds where the saving glut is simply a shift of the saving (supply) curve to the right.
What was interesting about the saving glut hypothesis is that it not only explained the decrease in interest rates but it was also able to account for the growth in global imbalances. One simple way to represent that is to separate the world in two blocks: those whose saving increased and the rest of the world. We can use again a simple demand and supply chart to represent this two group of countries: we represent the countries whose saving was increasing on the left hand side and the rest of the world on the right hand side to get the following picture:
This shows that we should expect the countries that increase their saving to display a growing current account surplus and the countries where the two curves are not shifting to display a growing current account deficit. This simple framework matches well the data during those years. Current account surplus in countries such as Germany, Japan, Oil producing countries, China and other emerging markets in Asia increased while deficits in countries such as the US and Greece, Spain, Portugal, Ireland, the UK increased as well. Here is the data (from the IMF World Economic Outlook):
But in this story there were some predictions that were never tested. In particular, as interest rates fell, investment should have increased globally. If you look at the saving and investment curves above, investment should have increased both in countries where the supply of saving was shifting as well as in the other countries. Unless we believe that investment rates do not depend on the interest rates we should have seen a generalized increased in investment around the world. Did we see that? No. In fact in advanced economies (including the US, as I showed yesterday) we have seen the opposite. Below is a chart that I have constructed using data from the IMF (World Economic Outlook database). I have calculated the aggregate investment rate (as % of GDP) for all advanced economies using the GDP share of each of these countries as weights [using PPP adjusted weights makes no difference for these countries].
There is a clear downward trend in the data. Even if we ignore the post-2008 data. the expansion in the 2000s was weaker that that of the 90s or the 80s. And remember that we expected exactly the opposite. The only way to make this last chart compatible with the saving glut story is to argue that at the same time that the saving curve was shifting to the right in some countries, the investment curve was also shifting (this time inwards) in other countries.
The shift of the investment curve would also help explain the lower interest rate during the decade. But in addition it would explain why growth rates (and labor market performance) remained weak during the expansion of the 2000s in some advanced economies. And given what we have seen so far during the current expansion it might be a source of additional pessimism about the coming years.
Antonio Fatás
It is a fact that since the mid 1990s interest rates in the world started a downward trend. This trend was explained by Ben Bernanke in his March 2005 speech
“To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain the relatively low level of long-term real interest rates in the world today”
This can easily be represented in a standard demand and supply chart for the global market for funds where the saving glut is simply a shift of the saving (supply) curve to the right.
What was interesting about the saving glut hypothesis is that it not only explained the decrease in interest rates but it was also able to account for the growth in global imbalances. One simple way to represent that is to separate the world in two blocks: those whose saving increased and the rest of the world. We can use again a simple demand and supply chart to represent this two group of countries: we represent the countries whose saving was increasing on the left hand side and the rest of the world on the right hand side to get the following picture:
This shows that we should expect the countries that increase their saving to display a growing current account surplus and the countries where the two curves are not shifting to display a growing current account deficit. This simple framework matches well the data during those years. Current account surplus in countries such as Germany, Japan, Oil producing countries, China and other emerging markets in Asia increased while deficits in countries such as the US and Greece, Spain, Portugal, Ireland, the UK increased as well. Here is the data (from the IMF World Economic Outlook):
But in this story there were some predictions that were never tested. In particular, as interest rates fell, investment should have increased globally. If you look at the saving and investment curves above, investment should have increased both in countries where the supply of saving was shifting as well as in the other countries. Unless we believe that investment rates do not depend on the interest rates we should have seen a generalized increased in investment around the world. Did we see that? No. In fact in advanced economies (including the US, as I showed yesterday) we have seen the opposite. Below is a chart that I have constructed using data from the IMF (World Economic Outlook database). I have calculated the aggregate investment rate (as % of GDP) for all advanced economies using the GDP share of each of these countries as weights [using PPP adjusted weights makes no difference for these countries].
There is a clear downward trend in the data. Even if we ignore the post-2008 data. the expansion in the 2000s was weaker that that of the 90s or the 80s. And remember that we expected exactly the opposite. The only way to make this last chart compatible with the saving glut story is to argue that at the same time that the saving curve was shifting to the right in some countries, the investment curve was also shifting (this time inwards) in other countries.
The shift of the investment curve would also help explain the lower interest rate during the decade. But in addition it would explain why growth rates (and labor market performance) remained weak during the expansion of the 2000s in some advanced economies. And given what we have seen so far during the current expansion it might be a source of additional pessimism about the coming years.
Antonio Fatás
Tuesday, November 19, 2013
Bubbles, interest rates and full employment.
The presentation of Larry Summers at a recent IMF conference has generated a good amount of comments. While some of what he said was not completely new, the way he put together some of these ideas to present a fairly pessimistic view of the state of the US economy has led to a debate around the possibility of secular stagnation (see Krugman). Secular stagnation refers to the fact that some of the output losses during the crisis become permanent, the economy does not ever return to the previous trend.
But there was something else that Larry Summers discussed that I also find interesting: he referred to the fact that in previous expansions the US economy barely managed to reach full employment despite the existence of strong bubbles and excesses. This also leads to a pessimistic view of the recent years and not so much because of what happened after 2008 but what happened before 2008.
Here is some data and a story to make you share that pessimism: it is a fact that global real interest rates during the last expansion (2001-2007) were very low by historical standards. The main candidate to explain low real interest rates is the saving glut that Ben Bernanke referred to in his 2005 speech to describe the increase in the pool of global saving coming from Asia, Germany, Japan and oil producing countries. As saving increase, the world interest rate fell. In other countries (such as the US and some European countries), this led to an increase in spending and borrowing that resulted in an increase in global imbalances.
But if what we saw in these years was an increase in the pool of saving that drove down interest rates we should expect investment to increase (as supply shifts we move along a downward slopping demand curve to find the new equilibrium price). And if investment increases we should expect an increase in growth rates. But none of this happened. In fact, investment not only did not go up but it was lower than what it had been in previous expansions as shown in the chart below (data is for the US economy).
When we compare the last four expansions in the US economy we can see that while the real interest rate kept going down (especially in the 2001-2007 expansion), investment rates remained flat or even declined. I have included the current expansion in the chart although is not comparable to the others as it has not finished yet.
What happened to investment? Why didn't it go up as real interest rates fell and the pool of saving was increasing? I am not sure we have an answer to these questions but what the data suggests is that we are not just facing the negative consequences of a deep recession, we should also have some concerns about the strength of the recovery based on the weakness of investment in the previous expansion (once we take into account the low level of interest rates).
Antonio Fatás
Sunday, November 17, 2013
Europe: lack of reforms or austerity?
In a recent Vox article, Lorenzo Bini Smaghi raises some questions about the argument that austerity is the main reason why European countries' growth rates have been so low since 2008. To be fair, he is open to the idea that austerity has done some damage but he suggests that structural issues are also responsible for what we have seen in Southern European countries.
His main argument can be summarized by a set of charts where growth during the 2008-2012 period is shown to be negatively correlated to measures of competitiveness. For example, comparing growth during the crisis with the competitiveness index produced by the World Economic Forum, one gets the following correlation:
So the argument is that the low growth performance of Southern Europe (and Ireland) during the crisis is related to their structural problems.
I will not disagrees with the statement that some of those countries have structural weaknesses that can constraint their growth rates. But I find that the chart above does not provide much insights on how much growth reforms could deliver or the extent to which lack of reforms are behind the depth of the recession in these countries.
My concern is the use of only 4 years to assess the effects of competitiveness. If structural weaknesses matter so much, they should affect growth in the long term (not just during crisis). If one compares the evolution of GDP growth since 1994 among some of these countries, the picture looks very different (click on the image for a larger version)
For every year in the period 1994-2009 (without exception) growth in Spain or Greece was higher than in Germany (and without the exception of 1998 this is also true when compared to Austria). It is only during the years 2010-2012 where Austria and Germany display faster growth rates than Spain and Greece. And it is in those years that austerity was the strongest. So what we have is countries where the amplitude of the business cycle is much larger. They did better during the good years and now they are doing worse, which is not a big surprise (e.g. the volatility of emerging markets tends to be larger than that of advanced economies). And given what happened in those years in terms of austerity and the fact that financial markets remain dysfunctional it is even less of a surprise. No doubt that structural weaknesses exist in these countries but their connection to growth is a complex one and cannot simply be assessed by looking at the last three years.
Antonio Fatás
His main argument can be summarized by a set of charts where growth during the 2008-2012 period is shown to be negatively correlated to measures of competitiveness. For example, comparing growth during the crisis with the competitiveness index produced by the World Economic Forum, one gets the following correlation:
So the argument is that the low growth performance of Southern Europe (and Ireland) during the crisis is related to their structural problems.
I will not disagrees with the statement that some of those countries have structural weaknesses that can constraint their growth rates. But I find that the chart above does not provide much insights on how much growth reforms could deliver or the extent to which lack of reforms are behind the depth of the recession in these countries.
My concern is the use of only 4 years to assess the effects of competitiveness. If structural weaknesses matter so much, they should affect growth in the long term (not just during crisis). If one compares the evolution of GDP growth since 1994 among some of these countries, the picture looks very different (click on the image for a larger version)
For every year in the period 1994-2009 (without exception) growth in Spain or Greece was higher than in Germany (and without the exception of 1998 this is also true when compared to Austria). It is only during the years 2010-2012 where Austria and Germany display faster growth rates than Spain and Greece. And it is in those years that austerity was the strongest. So what we have is countries where the amplitude of the business cycle is much larger. They did better during the good years and now they are doing worse, which is not a big surprise (e.g. the volatility of emerging markets tends to be larger than that of advanced economies). And given what happened in those years in terms of austerity and the fact that financial markets remain dysfunctional it is even less of a surprise. No doubt that structural weaknesses exist in these countries but their connection to growth is a complex one and cannot simply be assessed by looking at the last three years.
Antonio Fatás
Wednesday, November 13, 2013
Why Sinn was wrong to write this FT article
When I teach these days about the negative performance of the Euro economies over the last six years I always get asked about how policy makers could get it so wrong. The answer can be found in the article that Hans-Werner Sinn published today in the Financial Times (Why Draghi was wrong to cut interest rates). It is hard to know where to start commenting on the article. It is not only inconsistent but also full of arguments that go against any economic logic and misleading use of partial data.
Interestingly, the article starts with the argument that given that inflation in the Euro area is below its target and falling (down to 0.7% in October), it seems that "last week's interest rate cut is understandable". Correct. That's the only reasonable paragraph of the article as the next one opens with the sentence:
"However, deflation in parts of a currency union is not the same as deflation of a union as a whole, because its internal effects on competitiveness cannot be compensated for by exchange rate adjustment.".
Let me start with the first part of the sentence. It is interesting proposition to argue that the ECB should not manage just average inflation (and growth?) but also try to manage these variables at the regional variable. This is not the mandate of the ECB. And what is exactly what Hans-Werner Sinn proposes, that the ECB tries to keep inflation in any region (country?) of the Euro area below 2%? This will imply overall deflation in the Euro area.
The second part of the sentence is even worse. If it is true that we need a realignment of relative prices within the Euro area, you will NOT get it by keeping inflation low. The article argues that the "printing presses" from Souther Europe have slowed down the realignment of the relative prices of goods needed for improving competitiveness. Wrong. There is plenty of evidence that prices and wages exhibit downward nominal rigidity and that it is much easier to allow changes in relative prices when inflation is positive. It is the low inflation level of the Euro area that is limiting the adjustment in relative prices (Krugman makes this point today in his blog).
The article also argues that the ECB policies have kept the value of the Euro down and this is one of the reasons why the German economy is running a current account surplus (not sure which chart he is looking at to argue that the value of the Euro is low...).
Antonio Fatás
Interestingly, the article starts with the argument that given that inflation in the Euro area is below its target and falling (down to 0.7% in October), it seems that "last week's interest rate cut is understandable". Correct. That's the only reasonable paragraph of the article as the next one opens with the sentence:
"However, deflation in parts of a currency union is not the same as deflation of a union as a whole, because its internal effects on competitiveness cannot be compensated for by exchange rate adjustment.".
Let me start with the first part of the sentence. It is interesting proposition to argue that the ECB should not manage just average inflation (and growth?) but also try to manage these variables at the regional variable. This is not the mandate of the ECB. And what is exactly what Hans-Werner Sinn proposes, that the ECB tries to keep inflation in any region (country?) of the Euro area below 2%? This will imply overall deflation in the Euro area.
The second part of the sentence is even worse. If it is true that we need a realignment of relative prices within the Euro area, you will NOT get it by keeping inflation low. The article argues that the "printing presses" from Souther Europe have slowed down the realignment of the relative prices of goods needed for improving competitiveness. Wrong. There is plenty of evidence that prices and wages exhibit downward nominal rigidity and that it is much easier to allow changes in relative prices when inflation is positive. It is the low inflation level of the Euro area that is limiting the adjustment in relative prices (Krugman makes this point today in his blog).
The article also argues that the ECB policies have kept the value of the Euro down and this is one of the reasons why the German economy is running a current account surplus (not sure which chart he is looking at to argue that the value of the Euro is low...).
Antonio Fatás
Thursday, October 31, 2013
Party like it's 1995?
For some it is clear that the all-time record levels in the stock market are supported by loose monetary and the day policy starts changing, stock markets will suffer a sharp drop. While I also worry about the tendency of stock markets and investors to be overoptimistic, I am less concerned by the fact that we are hitting all-time record levels. First, we keep forgetting that we are talking about nominal variables and they will keep setting record levels as long as inflation remains positive. But I am also less worried because tightening of monetary policy normally happens when growth is picking up so the stock market will have to decide if they like more faster growth than higher interest rates. And the reaction might surprise some.
Whatever else might be wrong with the U.S. economy, the stock and bond markets of Wall Street are thriving on the strength of falling interest rates. Sluggish job growth, subdued consumer spending and worries about how the nation will fare in an increasingly competitive world have not stopped the steady advance of stock prices to record highs. Fort Worth Star-Telegram. August 26, 1993.
Fed Fears a Market Bubble If It Lowers Interest Rates. New York Times, September 16, 1993.
Stocks climb to a record Surge in bonds, lower interest rates are behind it. It was the Dow's fourth record close this month. The Associated Press, August 20, 1993.
Jump in interest rates sends shiver through bull market. The bull market that carried blue chip stocks to record highs last week may be running out of steam - and the next move could be nasty as small investors try to get out of the market, analysts say. Indeed, there is concern on Wall Street that the record flow of money into stock and bond mutual funds has created a potentially dangerous situation.
Signs of market fragility reappeared Friday when a jump in interest rates on the bond market triggered a selloff in stocks. The Washington Post, May 30, 1993.
A lot of these headlines look identical to the ones we read today. What happened in that historical episode can be seen in the chart below where I compare the evolution of the interest rate (Fed Funds Rate) with the Dow Jones Index (click for a larger image).
As interest rates started increasing towards the end of 1993 the stock market moved sideways (and it fell during some of the quarters). But as of the second quarter of 1994 the stock market recovered, paused towards the end of the year and then started a bull run that would continue for several years. What is interesting is that during 1995 monetary conditions continued to get tighter but the stock market kept booming. [I stopped my chart in 1996 but in the four years that followed the stock market doubled again]
I have no reason to expect the same behavior in the stock market this time (and given what happened after 2000, it might not be a desirable outcome), but these years serve as an illustration of how markets reacted positively to a significant reversal in monetary policy. Initially there was uncertainty and weakness in the stock market but it was later followed by strong optimism even if interest rates kept going up.
Antonio Fatás
A historical example that I have mentioned earlier and that I find interesting is the period 1993-1996. In 1993 the recovery from the previous recession was slowly taking shape and the stock market was going up and, yes, setting all-time records. What did the newspaper headlines say at the time and also in anticipation of a future when monetary policy was about to get tighter? A quick search in Google reveals the following headlines:
Whatever else might be wrong with the U.S. economy, the stock and bond markets of Wall Street are thriving on the strength of falling interest rates. Sluggish job growth, subdued consumer spending and worries about how the nation will fare in an increasingly competitive world have not stopped the steady advance of stock prices to record highs. Fort Worth Star-Telegram. August 26, 1993.
Fed Fears a Market Bubble If It Lowers Interest Rates. New York Times, September 16, 1993.
Stocks climb to a record Surge in bonds, lower interest rates are behind it. It was the Dow's fourth record close this month. The Associated Press, August 20, 1993.
Jump in interest rates sends shiver through bull market. The bull market that carried blue chip stocks to record highs last week may be running out of steam - and the next move could be nasty as small investors try to get out of the market, analysts say. Indeed, there is concern on Wall Street that the record flow of money into stock and bond mutual funds has created a potentially dangerous situation.
Signs of market fragility reappeared Friday when a jump in interest rates on the bond market triggered a selloff in stocks. The Washington Post, May 30, 1993.
A lot of these headlines look identical to the ones we read today. What happened in that historical episode can be seen in the chart below where I compare the evolution of the interest rate (Fed Funds Rate) with the Dow Jones Index (click for a larger image).
As interest rates started increasing towards the end of 1993 the stock market moved sideways (and it fell during some of the quarters). But as of the second quarter of 1994 the stock market recovered, paused towards the end of the year and then started a bull run that would continue for several years. What is interesting is that during 1995 monetary conditions continued to get tighter but the stock market kept booming. [I stopped my chart in 1996 but in the four years that followed the stock market doubled again]
I have no reason to expect the same behavior in the stock market this time (and given what happened after 2000, it might not be a desirable outcome), but these years serve as an illustration of how markets reacted positively to a significant reversal in monetary policy. Initially there was uncertainty and weakness in the stock market but it was later followed by strong optimism even if interest rates kept going up.
Antonio Fatás
Sunday, October 27, 2013
Sudden stops and exchange rates (again)
I did not realize that some of my earlier posts on sudden stops and the Euro area would be so controversial, I thought I was making a simple point. And this time those who disagree with me are the ones that I always agree with so it makes you think even harder about whether the argument that I was making are right!
Brad DeLong wrote a post yesterday to show that sudden (capital) stops should not be a concern for countries that have their own currencies. Let me start with all the arguments where I do not have any disagreement:
- Taking about the possibility of a sudden stop in the UK or the US makes no sense. I agree. The comparison that some establish to argue that the "US is the next Greece" is idiotic.
- Countries with fixed exchange rates that have accumulated a large amount of debt denominated in foreign currency are more likely to be exposed to crisis caused by sudden stops. Correct.
Where we disagree is on whether sudden stops are relevant to other countries with flexible exchange rates. My argument was that in cases where countries have been running large current account deficit for years, a sudden stop of capital could be contractionary (i.e. cause a crisis). Brad DeLong is more optimistic and argues (using the IS-LM model) that, on the contrary, a sudden stop will be expansionary because the exchange rate depreciation will boost exports. The argument is correct within the context of that model but I think that the model is missing several ingredients.There is no one real interest rate in financial markets. You might fix this by adding some risk premium to the model (e.g. the interest rate in the investment equation has an extra term). As long as that extra term is constant it will look as if you can still generate an expansion by controlling the real interest rate but I think that in some cases markets just fail to even provide a proper price for certain assets/risk and we are in a world with multiple equilibria (or simple some markets disappearing) and this changes the predictions of this very simple linear model. That is the point that Blanchard and Leigh do that Brad DeLong also disagrees with. I used to think that these scenarios where impossible in advanced economies but my view on financial markets and the possibility of multiple equilibria has changed substantially during the 2008-2013 crisis.
But is the real disagreement about financial markets or about the role of exchange rates as an adjustment mechanism during times of crisis? Let me argue that they are related. There is a divide between US and European economists when it comes to this debate. Even among those who come from similar ideological backgrounds and support similar models, I have found that US economists tend to put a larger weight on the benefits of flexible exchange rates. Europeans tend to be more skeptical. It might be because there is a bias (Europeans are "proud" of the Euro). But I think that there is also a belief that financial markets (and foreign exchange markets) are more imperfect than what the traditional model of flexible exchange rates suggest. Bubbles, mispricing of currencies, financial imperfections, animal spirits, multiple equibria all move you away from the theoretical benefits of flexible exchange rates.
Who is right? I have no disagreement with the logical arguments that Brad DeLong makes, but what would really make me change my mind is empirical evidence about the behavior of interest rates or exports or exchange rates during the crisis that supports those models (e.g. why did the depreciation of the british pound not have a larger effect on exports?). My latest post had been motivated by the results of Rose on the irrelevance of exchange rate regimes during the crisis. The results are interesting and suggest that exchange rates matter less than what we think. They are not definitive, there are always hypothesis that cannot be tested with the data we have but to me that's the only place to make progress in this debate, we need more and better empirical analysis.
[Update: Paul Krugman does not like my arguments either and he asks for a model. Fair point and I do not have one but I see my arguments as being consistent with models that others have written. Looking for one when I find more time. But my argument is mostly empirical: I cannot think of many countries where a sudden stop has led to an expansion. To be continued.]
Antonio Fatás
Brad DeLong wrote a post yesterday to show that sudden (capital) stops should not be a concern for countries that have their own currencies. Let me start with all the arguments where I do not have any disagreement:
- Taking about the possibility of a sudden stop in the UK or the US makes no sense. I agree. The comparison that some establish to argue that the "US is the next Greece" is idiotic.
- Countries with fixed exchange rates that have accumulated a large amount of debt denominated in foreign currency are more likely to be exposed to crisis caused by sudden stops. Correct.
Where we disagree is on whether sudden stops are relevant to other countries with flexible exchange rates. My argument was that in cases where countries have been running large current account deficit for years, a sudden stop of capital could be contractionary (i.e. cause a crisis). Brad DeLong is more optimistic and argues (using the IS-LM model) that, on the contrary, a sudden stop will be expansionary because the exchange rate depreciation will boost exports. The argument is correct within the context of that model but I think that the model is missing several ingredients.There is no one real interest rate in financial markets. You might fix this by adding some risk premium to the model (e.g. the interest rate in the investment equation has an extra term). As long as that extra term is constant it will look as if you can still generate an expansion by controlling the real interest rate but I think that in some cases markets just fail to even provide a proper price for certain assets/risk and we are in a world with multiple equilibria (or simple some markets disappearing) and this changes the predictions of this very simple linear model. That is the point that Blanchard and Leigh do that Brad DeLong also disagrees with. I used to think that these scenarios where impossible in advanced economies but my view on financial markets and the possibility of multiple equilibria has changed substantially during the 2008-2013 crisis.
But is the real disagreement about financial markets or about the role of exchange rates as an adjustment mechanism during times of crisis? Let me argue that they are related. There is a divide between US and European economists when it comes to this debate. Even among those who come from similar ideological backgrounds and support similar models, I have found that US economists tend to put a larger weight on the benefits of flexible exchange rates. Europeans tend to be more skeptical. It might be because there is a bias (Europeans are "proud" of the Euro). But I think that there is also a belief that financial markets (and foreign exchange markets) are more imperfect than what the traditional model of flexible exchange rates suggest. Bubbles, mispricing of currencies, financial imperfections, animal spirits, multiple equibria all move you away from the theoretical benefits of flexible exchange rates.
Who is right? I have no disagreement with the logical arguments that Brad DeLong makes, but what would really make me change my mind is empirical evidence about the behavior of interest rates or exports or exchange rates during the crisis that supports those models (e.g. why did the depreciation of the british pound not have a larger effect on exports?). My latest post had been motivated by the results of Rose on the irrelevance of exchange rate regimes during the crisis. The results are interesting and suggest that exchange rates matter less than what we think. They are not definitive, there are always hypothesis that cannot be tested with the data we have but to me that's the only place to make progress in this debate, we need more and better empirical analysis.
[Update: Paul Krugman does not like my arguments either and he asks for a model. Fair point and I do not have one but I see my arguments as being consistent with models that others have written. Looking for one when I find more time. But my argument is mostly empirical: I cannot think of many countries where a sudden stop has led to an expansion. To be continued.]
Antonio Fatás
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