Scott Sumner  

Exchange rate pegs are usually a bad idea

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Tyler Cowen has a post discussing the pressure being placed on the Danish krona, which is pegged to the euro:

And if the Danes cut their peg, I am loathe to call this a "mistake" (even though it likely will hurt their economy), rather it would be an inevitability.
Over the years I've argued that the Danes should have followed the Swedes and British, and let their currency float against the euro. That added flexibility allowed Sweden to recovery more quickly in 2010, although soon after that the Riksbank started ignoring the advice of Lars Svensson and foolishly tightened to try to pop a property "bubble." So I agree that ending currency pegs is not a "mistake" and indeed if Denmark let their currency float as the Swedes do they would probably be under less pressure from speculators. (It's actually not clear how much pressure (if any) they are under---does anyone have data on the Danish monetary base?)

So currency pegs are not a sensible policy. Why then did I criticize the SNB for ending their euro peg last week? Because while pegs are not good policies, there are far worse policies out there. And the Swiss adopted a much worse policy last week. Not just worse in some ways---worse in every way, including the risk assumed by the SNB.

Denmark should end the currency peg and adopt a better policy, such as price level or NGDP level targeting. If their new policy hurts the Danish economy (as Tyler thinks is likely) then the new policy would be a mistake. But it need not do so. And give the Danes credit for one thing; they increased the tax on bank reserves before ending the currency peg. The Swiss waited until after the currency was allowed to float, which was a very puzzling decision.

The Swiss peg was always viewed as temporary, whereas the Danish peg is viewed as semi-permanent. So you might think that delinking the SF to the euro should not have cost much credibility. And in a sense you would be right; the float is not the problem. The loss of credibility came from the 21% appreciation in the SF. The Swiss had previously pegged the exchange rate to try to stabilize prices. A 21% appreciation in the SF is not consistent with price stability, and that is the real reason they lost credibility. The fact that some Polish homeowners have seen their mortgages become more burdensome is beside the point. Then SNB never made any promises to keep the SF/euro rate fixed forever.

PS. If Denmark delinked their currency to the euro would it be an "inevitability" as Tyler claims? Yes, in the sense that we live in a completely deterministic universe (in my view.) No, in terms of every other sense of the word "inevitability."

PPS. Note that Tyler is NOT predicting the Danes will revalue. He is saying that if it happens it will have been inevitable. Because he is not predicting this outcome, its occurrence would not support his claim that the Swiss were pushed. That sort of support would require an actual prediction.

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CATEGORIES: Monetary Policy

COMMENTS (8 to date)
CMA writes:

Slightly off topic. Why has the fed targeted a lower level on inflation in recent years?

Ken from Ohio writes:

So let's suppose that the SCB had targeted a 5% NGDP as opposed to a currency peg.

I think it would have gone like this:

1)The SF would begin to increase relative to the Euro

2) The strong SF would impair Swiss exports and the Swiss GDP would trend down. (I think that 70% of Swiss GDP is derived from exports)

3) In order to keep its 5% NGDP target, the SCB would begin a QE of sorts- perhaps purchase Swiss government bonds- to create a monetary expansion.

4) The monetary expansion would prevent a further rise in the SF/Euro exchange rate - and the SF may find an equilibrium of around 1.2

5) The net difference between a NGDP target and a currency peg is that in the end, the SCB balance sheet would be holding Swiss government bonds from the QE- as opposed to foreign exchange from the attempt at currency peg.

Is this a reasonable scenario?

Scott Sumner writes:

CMA, I think it has been steady at about 2%.

Ken, It is hard to say how much QE is needed. And the supply of Swiss government bonds is not very large (AFAIK) so they might have to buy foreign bonds.

CMA writes:

"CMA, I think it has been steady at about 2%."

Then how is inflation lower than 2%?

Scott Sumner writes:

CMA, They have recently undershot the target. Also recall they are not strict inflation targeters, they have a dual mandate. If they always hit 2% inflation they would be violating the law.

Nick writes:

'CMA, They have recently undershot the target. Also recall they are not strict inflation targeters, they have a dual mandate. If they always hit 2% inflation they would be violating the law.'

Indeed. When unemployment is high, the Fed is required to try and bring it down. But how? Strengthen the economy, of course. And since low inflation strengthens the economy, that's what they've been doing to help for the last six years...
The thing I can't figure out is why businesses don't take all the money they are saving on menu costs and reinvest it! And that doesn't even take into account consumer savings on shoe repair.

Jason writes:

Nick, I can't tell if you are joking, or if you just haven't read anything Scott has written before.

Nick writes:

Why, does something in my previous comment not make sense???
Joking, of course.

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