Currencies, Capital Flows and Crises

A Post Keynesian Analysis of Exchange Rate Determination

John T. Harvey

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781135969097
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Breaking from conventional wisdom, this book provides an explanation of exchange rates based on the premise that it is financial capital flows and not international trade that represents the driving force behind currency movements. John T. Harvey combines analyses rooted in the scholarly traditions of John Maynard Keynes and Thorstein Veblen with that of modern psychology to produce a set of new theories to explain international monetary economics, including not only exchange rates but also world financial crises.

In the book, the traditional approach is reviewed and critiqued and the alternative is then built by studying the psychology of the market and balance of payments questions. The central model has at its core Keynes' analysis of the macroeconomy and it assumes neither full employment nor balanced trade over the short or long run. Market participants' mental model, which they use to forecast future exchange rate movements, is specified and integrated into the explanation. A separate but related discussion of currency crises shows that three distinct tension points emerge in booming economies, any one of which can break and signal the collapse. Each of the models is compared to post-Bretton Woods history and the reader is shown exactly how various shifts and adjustments on the graphs can explain the dollar's ups and downs and the Mexican (1994) and Asian (1987) crises.

1
Introduction

From 1980 to 1985, the value of the dollar in terms of the Deutsche Mark more than doubled. Immediately thereafter (and in less time) it did a complete reversal. In December of 1994, the Mexican peso lost almost sixty percent of its value against the dollar in just two weeks. The South Korean won plummeted from 891 per dollar on August 4, 1997, to 1,812 by January 9 of the next year. At the time of this writing (spring 2008) the dollar is in the midst of a historic collapse. Each of these extraordinary upheavals was accompanied by macro consequences that went well beyond currency markets and shifted economic activity onto new paths. These were not trivial events or a sideshow, they were center stage.

Despite the central importance of the market for foreign currency, mainstream economists are unable to agree on how it works. There is no single, well-accepted explanation (as in neoclassical trade theory, for example), but a smorgasbord of choices. These include, though are not limited to, purchasing power parity, the monetary model, the Dornbusch model, portfolio balance, Mundell-Fleming, currency substitution, fundamentalists versus chartists, microstructure studies, and order flow. While there is some agreement on the general principles that 1) short-run movements may be driven by non-fundamental factors (some going so far as to admit that less-than-rational expectations may play a role) and 2) long-run currency prices move economies toward optimal levels (typically a balanced-trade equilibrium), there appears to be little interest in modeling the former and little agreement on the specifics of the latter.

The simultaneous co-existence of so many approaches along with a general shift to long-run studies is a function of the poor empirical performance of each individual Neoclassical model. First highlighted by Richard Meese and Kenneth Rogoff (1983), these troubles have continued unabated (Rogoff 2001), so much so that it is now common to include a mention of this even at the textbook level.¹ The real problem, of course, is the fact that the Neoclassical paradigm is poorly equipped to explain a world marked by less-than-full employment, fundamental uncertainty, endogenous money, historical time, equilibrium trade imbalances, and agents whose preferences and worldviews are a function of social rather than internal and atomistic influences. This is glaringly obvious over the short run, though no less true in the long run.

By contrast, the model developed in this book has no difficulty in explaining modern currency markets. Coming from the Post Keynesian perspective, it resorts to neither “ad hocery” nor special cases to account for the salient features of the international financial system and it is a single, coherent explanation. The unique element of the approach adopted here is the assumption that portfolio capital flows are not, in either the short or long run, passive and accommodating, but an independent and dominant force in setting exchange rates. In such a world, subjective speculative pressures can create wild swings in prices and, unless agents happen by coincidence to focus on trade balances as the primary factor driving their forecast of future exchange rate movements, there is no reason to believe that international flows of goods and services play any more than a secondary role in determining currency prices over any time horizon. Furthermore and in contrast to the mainstream practice, agents’ expectations are modeled as a real, causal element in the determination of currency prices and not simply as the source of white noise around a long-term, fundamental trend. This is a strong break and will require forays into Institutionalism and psychology, as well as Post Keynesian economics.

What evidence is there to justify shifting the focus (short and long term) to capital flows? That their absolute volume is extremely large is undeniable. A 2004 Bank for International Settlements (BIS) survey of currency markets showed that the average daily value of currency transactions (based on April of that year and net of double counting) was around $1.9 trillion (BIS 2005:1) – enough to accommodate world trade 40 times over (BIS 2005:1; World Trade Organization 2005:3). Even assuming a number of covering transactions for each import and export, it is clear that the overwhelming majority of foreign exchange transactions are related to capital. Mainstream economics does not necessarily deny this, but assumes that these activities have no net long-run impact on currency prices. Either they are white noise or they are a mere reflection of trade flows.

Whether or not this last point is true is crucial. If it is the case that capital flows have no lasting effect on foreign exchange prices then, for all intents and purposes, currency demand arises only from import-export transactions. In that event, short-term trade imbalances would indeed be as fleeting as argued in mainstream economics. Consider that argument. When a nation imports, they supply their home money in exchange for foreign so that they can use the latter to buy foreign goods and services. Imports thus translate into home currency supply. When they export, this creates a demand for their currency as foreigners buy it to obtain the home country’s goods and services: exports are home currency demand. Therefore, any country with a trade deficit must necessarily be experiencing an excess supply of the home currency, driving its price lower and making their products increasingly inexpensive. This process continues until balanced trade is restored. Meanwhile, countries with trade surpluses would be witness to own-currency appreciation until balance was restored.

So, in a world where capital flows are white noise or a reflection of trade flows, current accounts would tend toward balance. Exchange rate models would logically focus on imports and exports as the primary determinants of currency prices, particularly over the long run. In addition, because trade flows change only slowly, the international monetary system would be marked by smoothly adjusting currency prices. In a world where trade flows rule the roost, volatility and trade imbalances would be the exception. Capital flows may add some short-term drama, but they would have no lasting effect.

Now imagine instead if the factors driving those massive financial capital flows were fundamentally distinct from those determining trade flows, undertaken by different people with different agendas, worldviews, goals, et cetera. In that event, just because a nation is experiencing a trade imbalance does not mean that its currency price is out of line with its short- or long-term equilibrium. Recall that in the example in the previous paragraph the nation in question experienced a currency price depreciation because the trade deficit was evidence of an excess supply of its currency. But with large and independent capital flows, the trade balance tells only a small part of the story. So long as the nation in question is running a capital account surplus to offset the trade deficit, it is quite possible that their currency price is stable and could even be appreciating, just as the US dollar was during the rising trade deficits of the early 1980s. The tendency towards balanced trade is gone.² In addition, because the pursuit of short-term capital gain is driven by subjective and potentially unstable factors, the magnitude and direction of capital flows can change very quickly. Bandwagon effects, over-reaction, and fluctuating levels of confidence in agents’ forecasts combine to create a very different market dynamic than that created by trade flows. This is the world described by the models in this book and, more importantly, it is the one in which we live.

INSTITUTIONALIST AND POST KEYNESIAN ECONOMICS AND PSYCHOLOGY

Institutionalist economics

Though the Post Keynesian influence on this volume is the most obvious, the analysis is firmly and self-consciously set in an Institutionalist framework. Institutionalists view the economy from a broad perspective wherein markets are perceived as social institutions

like democracy and marriage … not physical phenomena such as light waves or friction. They serve to organize and guide human behavior through sanctions (formal and informal, negative and positive), mores, norms, status, and shared worldviews. Activities of markets are the activities of people and societies.

(Harvey 1993b: 679)

Capitalism (or any form of economic organization) is no more “natural” than the English language, indentured servitude, or Major League Baseball. Each is the result of a particular line of social evolution. In contrast to mainstream suggestions that economic behavior is subject to immutable laws, Institutionalism asserts that we are not dealing with universal phenomena. While there certainly are generalities (as explained below), they are to be discovered and not assumed.

Social institutions recreate themselves through constant evaluation of the behavior of their members. Behavior that meets the social standard is rewarded and thus encouraged and perpetuated; that which does not is punished. Because humans are social animals, this is done primarily by the members themselves as they strive to adhere to established conventions and thereby gain the approval of the “tribe” (the other members of the gang, fellow Texans, or the subculture of currency dealers, for example).³ According to Institutionalists, the relevant evaluative criteria can be divided into two sets: instrumental and ceremonial. Acts sanctioned by the former are rational and pragmatic. Something is “right” because it works, without reference to the way things were done before. Instrumental values lead to goal-oriented, experimental, and progressive action and they contribute to social provisioning (providing for the basic needs of all members of the economy) and democratic problem-solving (resolving the issues faced by the average person). By contrast, ceremony is concerned with tradition and power. A pattern of behavior is justified by appeal to the past and often implies invidious distinction. The tradition in western culture that a woman takes the surname of her husband, for example, is defended simply on the basis of “that is the way it is done” and it is, at least historically, an indication of her status as de facto property.

Societies and subcultures dominated by ceremonial valuing are marked by institutions that tend to be exploitative rather than creative. One manifestation of this occurs when groups and individuals focus on devising means of keeping or taking power, goods, wealth, land, et cetera from others not identified by some culture-specific standard as “us.” This is very common in nations with serious ethnic, religious, political, or other divisions and is a frequent problem in developing nations. Developed economies are not immune, however, and the nature and effect of institutions like sexism and racism can be explained by ceremony. Institutionalists also describe “business” as a ceremonial phenomenon. The goal of business is the accumulation of wealth and hence its orientation is power and exploitation, not democratic problem-solving. If policy makers can create an environment in which businesses only achieve wealth if they have solved some social problem, then it is possible to link the ceremonial to the instrumental. But in general it is important to remember that encouraging business is not equivalent to encouraging social welfare.⁴

What all this means for foreign exchange is that, first, a key consideration must be to determine the manner in which the institution is organized and whether this organization is conducive to social provisioning or exploitation. This theme runs throughout this book, if often in the background, and therefore the analysis must delve into the specific subculture of currency markets as well as the worldviews of those therein. It also means there is no a priori assumption that markets are the best way to solve social problems or that they are inherently flawed or morally wrong. Markets are tools, no more and no less; their propriety is a function of their ability to solve the problem at hand. Nor is it assumed that market behavior is rational (by whatever definition). Markets are people in a particular social setting. What markets reflect, reward, and encourage is a direct function of what is reflected, rewarded, and encouraged in that society. If a culture is racist, an employer daring to hire a member of the oppressed race may lose sales as customers turn away. If in an asset market agents focus on sun spots in forecasting future prices, those not doing so will find themselves with depreciating portfolios. That markets are people and people are social animals is an important premise of this work and the primary influence of the Institutionalist approach on this volume.

Post Keynesian economics

While the Institutionalist perspective is vital in understanding the context in which the market for foreign exchange exists and the manner in which it is organized, this book can best be described as Post Keynesian. The latter is indispensable in this endeavor because it offers unique insight into the working of modern capitalist economies and into the primary factor driving foreign currency prices: asset markets. Post Keynesians trace their intellectual heritage to John Maynard Keynes. Like Keynes, they see the assumption that agents view the future to be uncertain as critical to understanding real world economies. It is because of this that economies can come to rest at less-than-full employment. This is best explained through an example.

Assume a closed economy with no government sector. Let Y represent aggregate output, income, and expenditure (each of which must be equal to the other in a closed system), S aggregate savings, C aggregate consumption, and I aggregate investment.⁵ There are only two sectors: households and firms; and for simplicity let only the former earn income, consume, and save while only the latter may borrow (which, since they do not retain earnings, they must do in order to invest).

Household income (Y) can be either spent (as consumption, or C) or saved (S). This is shown in 1.1:

Y = C + S

1.1

Equation 1.2 illustrates the fact th...

Table of contents

• Routledge Advances in Heterodox Economics
• Contents
• Figures
• Acknowledgments
• 1 Introduction
• 2 Neoclassical approaches to exchange rate determination1
• 3 Psychology and decision-making in the foreign exchange market1
• 4 Leakages, injections, exchange rates, and trade (im)balances
• 5 Post Keynesian exchange rate modeling
• 6 Real-world applications
• 7 Problems and policy
• 8 Conclusions
• Notes
• Bibliography
• Index