The following is an extended response to discussion on the Post Keynesian discussion list. You can join the festivities by contacting http://csf.colorado.edu/pkt/
Foreign
Exchange and BSE/ELR Programs
This is a follow-up discussion related
to my original inquiry on February 24 regarding a BSE program and floating or
flexible exchange rates. I appreciate the responses from Davidson, O’Donnell,
Mosler and Forstater. These initial responses have lead me to review what little
material I could find on how instituting a BSE/ELR type of program might affect
the balance of payments. Concurrent to this issue is whether a fixed or flexible
floating rate exchange is the ideal choice. In the following discussion, I will
try to outline my analysis of the information and hopefully instigate further
discussion of this important policy issue in addressing problems of
unemployment, price stability and balance of payment questions. The complete
references used in this study are provided at the end.
To set the stage for this discussion, let me first state that the
implementation of a BSE/ELR type of program is a desirable policy goal. Given
the tenets of functional finance, as excellently discussed by Randy Wray in his
latest book, the ability for a government to implement this program is accepted
as correct. Therefore, the discussion of whether this is desirable or even
obtainable is set aside. Equally the issue of whether "fiat" money is indeed tax
driven, as outlined by Mosler, Mitchell, Wray and Forstater, is accepted as a
"sufficient" if not a necessary reason for determining the value of a fiat
currency. The ability to maintain stable prices by this monetary policy is
accepted. Thus my focus is upon the conditions of international exchange and how
domestic policies to eliminate unemployment affect this exchange.
The focus of the discussion is the writings of the proponents of a BSE/ELR
type of program that stress the need for "flexible" exchange rates in this type
of policy implementation. Against this background are the writings of Davidson
that stress a return to a "fixed" exchange rate to control the de-stabilizing
effects of rapid capital flows in the international community. While Davidson
does not specifically address this issue within the backdrop of a BSE/ELR
program, inferences can be drawn from his work with regard to the desirability
of a fixed exchange rate under this type of domestic program.
A brief digression into historical analysis is needed at this point. Until
the early 1970’s, most of the major world economies operated under a fixed
exchange rate regime. Davidson notes that during the period from 1950 to 1973,
the real growth rate of the GDP for OECD nations was almost twice the peak of
the industrial revolution. Since 1973, when flexible exchange rates returned,
growth has been almost half the 1950 to 1973 period. Equally in this period,
unemployment has reached double digit levels in many of the OECD economies
(1998a, pp. 3-4). Steady growth is desirable in order to help offset any
inflationary tendencies that will arise when a government maintains a deficit
monetary policy that would arise from the BSE/ELR program. Additionally, with
the return to flexible exchange rates since the 1970’s, the growth in daily
volume of international exchange has grown enormously. It is estimated the daily global turnover on
the organized exchanges in 1998 was $1.599 trillion (Cross, 1998, p. 5). Due to
this enormous growth in international volume, the ability of governments to make
and implement domestic monetary and fiscal policies are said to be diminished.
This particularly becomes true when continuous and persistent deficits or
surpluses occur within one country’s balance of trade. (Although the US may
represent one situation that has tended to avoid any major detrimental effects
from its persistent deficit due the $ being used as a "store of value" or as a
"vehicle" for international transactions.) Thus with the implementation of a
BSE/ELR type of program, analysis must be provided on how this will affect the
current balance of trade position.
Discussion
Mosler, in "Exchange Rate Policy and Full Employment," and Mosler and Forstater, in "A General
Analytical Framework for the Analysis of Currencies and Other Commodities,"
and Mitchell, in "The Buffer Stock Employment Model in a Small Open Economy," have provided a starting point to begin an analysis of this
issue. Beginning with Mosler’s work, Mosler states, "The combination of BSE and
floating exchange rates directly insures sustained full employment by definition
and should promote favorable terms of trade as later discussed" (p. 1). Mosler
goes on to analyze two situations in which the exchange rate was essentially
"fixed" to the $US. The first is an analysis of Russia that was unable to set
its interest rate exogeneously due to the convertibility of rubles for $ at the
CB. With the suspension of convertibility in August of 1998, the result is said
to be a floating exchange rate regime in which Russia can now practice
functional finance to remedy its situation. Thus a BSE/ELR type of program could
be instituted without further drains of its $US reserves.
The other example was centered on the "currency board" regime in HK. In order
for HK to implement a BSE/ELR program, it would have to obtain more $ US to
protect its reserves. In this example, the exchange is fixed to the $US putting
a constraint on domestic independence. Based on these two situations, Mosler
states:
"If a government chooses a fixed exchange rate policy, and simultaneously
attempts to achieve full employment, it could very well lose its foreign
exchange reserves. Interest rates would be rising, as expressed by the forward
price of the Thus for Mosler, in order for a BSE/ELR program to be effective, flexible
exchange rates are needed.
A similar analysis is found in the Mosler and Forstater work. In analyzing
the Asian Crisis of 1997, they state that the maintenance of a "pegged exchange
rate," another type of fixed exchange, set up a situation that proved
destabilizing. The results of this peg are described as:
However, when the private sector turned to being net sellers of the local
currency From this discussion, it can be inferred that a fixed exchange rate was
disastrous for the local currencies. Due to the "pegged" nature of the exchange,
any attempt to implement a BSE/ELR program would either drain $US reserves or
cause further devaluation of the currency with its attendant inflationary
effects. Price stability is undermined and unemployment increases. This is
readily exemplified Asian contagion over the last two years.
Mitchell continues this line of thought in the analysis of inflation and
short/long interest rates in connection with a BSE/ELR program. From this comes
the important conclusion that,
Under fixed exchange rates, globalisation of financial markets lead to a
convergence of both short-term and long-term interest rates across countries
within the exchange rate bloc. The rates also tend to move together and are thus
determined by shared conditions. Individual economies cannot run independent
monetary policy (p. 11).
From these discussions, it is clear that the originators of the BSE/ELR
programs are solidly in agreement that a floating exchange rate policy is
necessary for implementation. The positive benefit of a floating exchange rate
is further collaborated by Meulendyke who states "domestic policy actions are
more independent than under relatively fixed exchange rates because policy is
less constrained by official balance of payments settlements" (p. 209). In this
scenario, monetary policy can be reinforced. She goes on to state:
For example, a tightening of monetary policy, ceteris paribus, tends to
restrain At this point, it might be easy to accept these conclusions as consistent and
argue for a regime of flexible exchange rates. However, Davidson has provided
excellent analysis in arguing for a return to a fixed exchange regime, also
known as the Bancor plan. While Davidson does not address his arguments within
the BSE/ELR framework, certain implications can be drawn from his work. Key to
this work is the understanding that expectations in a non-ergodic international
world are subject to rapid and often destabilizing effects on the balance of
trade. In "International Money and the Real
World," Davidson elaborates how the floating
exchange rate contributes to destabilization. He describes these effects as
follows:
If, however, a freely flexible (or even a crawling peg) exchange rate system
is in The focus of Davidson's analysis is upon the amount of investment undertaken
in an uncertain world. If greater volatility is evidence in the FX markets,
investment decisions may be hindered or reduced.
This has important implications when considering a BSE/ELR type of program.
Keynesian stimulus is designed to provide for increasing demand that, ceteris
paribus, brings forth more investment. (It should be noted that this stimulus is
not just the simple "printing of money" that is so often attributed to Keynesian
policies.) While this demand certainly would result in a closed economy with
increased internal investment, in an open economy this stimulus must be weighed
carefully against balance of payment considerations. Mohsen Bahmani-Oskooee has
indicated in a study of data for the period 1973-1988 that budget deficits raise
import volumes and lower export volumes "in the short run as well as in the long
run" (1991, p. 80). Since the Mosler-Mitchell-Forstater model relies on deficit
monetary policy, it is evident that a serious balance of payments' problem could
arise under the BSE/ELR proposal. The resulting deficit in the balance of
payments can make investment unattractive even if the deficit country is running
at full employment. This is due to the fact that a deficit balance of payment
over time, ceteris paribus, will lower the foreign exchange value of the deficit
nation and instigate uncertainty as to the future profitability of investments.
As Davidson states in another paper, "Until we reform the world’s international
payments system it will be impossible for any individual nation, except perhaps
the United States, to undertake national macro policies to maintain high levels
of aggregate demand internally without fear of a balance of payments constraint"
(1998a, p. 7).
The important issue in this discussion is centered on investment incentives
and uncertainty. In a expansionary policy like the BSE/ELR program, capital
flows for investment will be impacted by the expectations of return and the
needs for liquidity. If the expansion is viewed as inflationary, investment will
be constrained as participants wait for more stabilization of price levels. This
constraint on investment could have de-stabilizing affects due to the
bottlenecks in production to meet the demand of the expanded work-force.
Another important consideration to this discussion is that Davidson attaches
his fixed exchange regime to the existence of an international clearing
mechanisms to provide for stability within the markets. The specifics of his
recommendation are well known and need not be repeated here. However, it is
important to this discussion to recognize that this "market-maker" is an
important aspect to a fixed exchange regime.
One final background work that might be relevant to these discussions is
provided by Sheila Dow. In her paper on monetary theory for an open economy, Dow
examines monetary policy in both fixed and flexible exchange rate
considerations. She provides an interesting conclusion that is stated as
follows:
Whether exchange rates are more or less flexible
determines primarily the The important fact that is drawn out by Dow’s paper is that instability can
result under either a fixed or flexible regime as presently practiced.
Concluding Analysis
The goal of this discussion is to provide
clarity in formulating a comprehensive policy program based on functional
finance. One aspect of this program involves the implementation of a BSE/ELR or
similar type of program. As Warren, Mitchell and Forstater have expounded, a
BSE/ELR type of program can provide an avenue to ensure full employment and
price stability. Equally, Davidson has also demonstrated in his works that
unless an international regime of controls on the exchange market are instituted
that de-stabilizing macro affects are likely to continue, thus hampering
monetary policy from being pursued in exclusion to exchange factors. The major
difference as revealed in the above discussion is on the issue of flexible or
fixed exchange rate regimes.
Interesting enough, in all the discussion that Warren, Mitchell and Forstater
have expressed, the fixed exchange rate policy is different from that advocated
by Davidson. By this I mean they either involved pegs to the $US or involved the
use of currency boards. In reaching their conclusions, these types of fixed
exchange regimes have been shown to be detrimental to the economic situation.
Thus, floating exchange rates should remain. However, it is clear from
Davidson’s work that the fixed exchange rate regime he proposes solves many of
the current deficiencies of the present system. Equally attractive is the fact
that Davidsons’ program would eliminate a number of problems that have been
associated with the flexible exchange rate and its hybrid fixed forms, such as
the speculative motive. (Even today we have a commercial on TV that touts the
ability to make $40,000 off a $10,000 investment in ONE MONTH in currency
exchanges!) While Dow may be correct that under either regime, expansions and
contractions will have de-stabilizing affects, it appears that greater stability
can be ensured under a fixed exchange rate regime with its accompanying
international market maker that Davidson proposes. In fact, it would seem that
any implementation of a BSE/ELR program would work better if implemented with
the Davidson program for international settlements. The Davidson proposal
eliminates many of the problems that are voiced by the BSE/ELR proponents.
Countries with persistent balance of trade deficits or surpluses would have a
stabilizing institution to bring order to the market.
Having said this, let me restate my original desire for this discussion. It
is to be hoped that this will inspire better clarity and discussion to the
advantage of one FX regime over the other. My conclusions are preliminary and
certainly not dogmatic at this point. Yet the overwhelming needs for
international capital controls and the immediate need for providing for
full-employment are one side of the same issue that must be addressed. This
issue is in assuring that any full-employment policy will not have negative or
destabilizing influences on other economic participants in a global environment.
It is also important to recognize that capital flows under a stable state of
expectations can provide much of the investment needed to finance the demand
that full employment will produce.
Perhaps the esteemed words of Abba Lerner are in order at this point:
The central idea is that government fiscal policy, its spending and
taxing, Comments and discussion encouraged.
Scott R. Simpson
References
Bahmani-Oskooee, Mohsen (1991), "U.S. Federal
Deficits and Trade Flows," Cross, Sam (1998), All About the Foreign
Exchange Market in the United States, Davidson, Paul (1992), International Money and
The Real World, New York: St. Martins Davidson, Paul (1998a), The Case for Regulating
International Capital Flows, Davidson, Paul (1998b), Volatile Financial
Markets and the Speculator, Dow, Shiela (1986), "Post Keynesian Monetary Theory for an Open
Economy," Lerner, Abba (1943), "Functional Finance and the Federal Debt," Social Research, Meulendyke, Ann-Marie (1998), U.S. Monetary
Policy and Financial Markets, Mitchell, William (1998), The Buffer Stock
Employment Model in a Small Open Mosler, Warren & Forstater, Matthew (1998), A General Analytical Framework for the Mosler Warren (1998), Exchange Rate Policy and
Full Employment, (available at
http://www.warrenmosler.com).
Wray, Randall (1998), Understanding Modern
Money: The Key to Full Employment
currency falling while the spot price is being supported by a
diminishing pool of
fx reserves" (p. 8).
to pay their $US obligations the central banks were reluctant to
lose their $US
reserves to support the local currency and instead let it
float downward. At the
lower foreign exchange rates the local businesses were
unable to meet their $US
obligations and a liquidity crisis, which is still
not resolved followed (pp. 8-9).
U.S. inflation and, over time, economic
growth, driving up the dollar’s
exchange rate. A higher exchange rate, in
turn, shifts trade from the United
States to other countries and contributes
to slowing U.S. economic growth
(p. 209).
operation, then the elasticity of expectations is not constrained to
values close to
Zero by the prevailing institutional structure of the foreign
exchange market. Thus
a small decline in the spot exchange rate would not
automatically induce an
expectation that this was a temporary deviation from
a normal rate. Uncertainty
about future gains or losses will (by definition)
necessarily be significantly greater
than in a fixed exchange rate system (p.
261).
limitation put on the supply of finance during an
expansion; the more fixed are
exchange rates, the greater the scope for
capital inflows to continue to finance an
expansion. With fixed exchange
rates, the responsiveness of supply to changes in
expected returns
increases; with floating exchange rates, it is demand which
becomes more
elastic. Since either of these increases the tendency towards
financial ease
in an expansion and tightness in a contraction, the general statement
may be
made that economic openness increases the scope for instability (1986,
p.
254).
its borrowing and repayment of loans, its
issue of new money and its
withdrawal of money, shall all be undertaken with
an eye only to the
results of these actions on the economy and not to any
established
traditional doctrine about what is sound or unsound (p. 39).
Journal of Post
Keynesian Economics, Fall, vol. 14, no. 1, pp.
72-82.
New
York: Federal Reserve Bank of New York.
Press.
(available at
http://csf.colorado.edu/pkt/authors/Davidson.Paul/papers.html).
(available at
http://csf.colorado.edu/pkt/authors/Davidson.Paul/papers.html).
Journal of Post Keynesian
Economics, Winter, vol. IX, no. 2. pp. 237-256.
vol.
10, pp. 38-51.
New York:
Federal Reserve Bank of New York.
Economy,
(available at
http://econ-www.newcastle-edu.au/economics/research/
bse-openeconomy.pdf).
Analysis of Currencies and
Other Commodities, (available at
http://www.warrenmosler.com).
and Price Stability, (Vermont: Edward Elgar.)
© CopyRight 2002 Scott R. Simpson