But How Many of Those Countries Saw Their Currencies Appreciate?

A few months ago an astute commenter mentioned a study (was it an IMF study by Rogoff?) that examined nearly 100 previous financial crises. He said they found that real GDP fell sharply in every case. He then used this evidence to refute my argument that easier money could have prevented a severe collapse in output during the late 2008 financial crisis. My response was “yeah, but how many of those countries saw their currencies sharply appreciate during the midst of the financial crisis.” I’d like to return to this issue, but first I will discuss recent market news.

I was pleasantly surprised to see that the stock market rose strongly this morning, and noticed some interesting comments in the press. One story (which I can’t find) mentioned that sentiment was helped by a sharp rebound in China. For months I have been arguing that the strong rebound in East Asia is the most likely cause of the “green shots” now visible in the markets (although not yet the broader economy.) A more interesting story discussed an increased appetite for risk which was depressing the dollar:

NEW YORK, July 30 – The U.S. dollar fell against a basket of currencies on Thursday as a firmer tone in world equity and commodity markets eroded demand for the greenback as a safe haven.

U.S. stock futures pointed to a higher open, while European shares rallied and crude oil prices advanced above $64 a barrel.

That boosted investors’ appetite for risk and helped the euro and perceived higher-risk currencies to recoup some of the previous day’s sharp losses.

” futures are looking good,” said Ronald Simpson, managing director of global currency analysis at Action Economics in Tampa, Florida. “It’s generally the risk appetite scenario once again.”

. . .

Perceived higher risk and commodity-linked currencies such as the Australian and Canadian dollars rallied, with sentiment buoyed by gains in Chinese shares and a recovery in oil prices.

China’s benchmark Shanghai Composite Index ended 1.7 percent higher following a 5 percent loss in the previous session after a senior central banker said loose monetary policies would not be reversed.

In my research on the Great Depression I often found that when a certain factor (such as gold hoarding) caused a sharply stock market decline, the reversal of that factor was associated with an equally sharp rebound. One of the odd things about the financial crisis in late 2008 was that the dollar rallied strongly. I know this sounds far-fetched, but is it possible that the US financial crisis did so much damage to the rest of the world that investors seeking a safe haven perversely piled into the currency of the country that triggered the crisis? Previously I had mostly argued that the rise of the dollar last fall was a symptom of tight money. I still believe that. But the scale of the appreciation against the euro was astounding, especially given that monetary policy in Europe was also very tight. (I seem to recall that the euro fell from around 1.60 to 1.25 between July and November.)

Now let’s consider this news story. It says that growth in the developing world is increasing investor appetite for risk. Note that Chinese and HK stocks have outperformed even the US indices. And what happens to the dollar on the news? It falls. And US stocks soar. This certainly doesn’t prove anything, but if we are seeing a reversal of what happened last fall then maybe the rise in the dollar back then was caused by both tight money and a flight to safety. Note that the financial crisis was itself partly caused by the tight money, so it is difficult to disentangle all of these effects. But this did get me thinking about that question posed by my commenter—how did the recent US financial crisis compare to others?

I’m no expert of financial crises, but my impression is that the typical Thai/Mexican/Russian financial crisis was associated with currency depreciation. If so, then those crises are not models for the US. I know of one other crisis that definitely saw a currency appreciation, and one that might have. I’ll start with the maybe.

Argentina had its currency linked to the dollar from about the early 1990s to 2001. If I am not mistaken, the dollar was very strong around 1999-2001, dragging the Argentine peso up with it. And I also recall they had a financial crisis and depression at his time. Argentina had deflation when much of the world was booming. Could the depression have been prevented by a floating exchange rate combined with inflation targeting? I think so; the policy seems to work pretty well in Chile.

The other case, which I know much more about, was the US from December 1930 to March 1933. During those 27 months the dollar was tied to gold. Nevertheless, the dollar did appreciate strongly because many countries sharply devalued their currencies, and no country revalued their currency. During this period the US experienced several banking crises, which became increasingly more severe. And of course there was a deep depression.

So those are the two financial crises that I can think of that are similar to our recent crisis. Was monetary policy to blame? I don’t know a lot about Argentina, but in the early 1930s very few Americans thought that tight money was causing the Depression. After all, rates had been cut to very low levels, and the Fed sharply increased the monetary base. And of course people are saying the same thing today. Only a few academic eggheads like Irving Fisher argued that money was too tight.

One other thing, today Irving Fisher’s eccentric view is pretty close to conventional wisdom.

There are two ways to visualize this recent upswing, for those of you confused by my ”tight money” argument. One is the point that Bill Woolsey keeps emphasizing, that an increased demand for money has the same effect as tight money. With greater appetite for risk, there is perhaps less demand for dollars, and this is expansionary. Or we could use the Wicksellian interest rate approach. The increased appetite for risk translates into a higher Wicksellian equilibrium rate. Because the policy rate is stuck at zero, this slightly eases monetary policy. Is it enough? No, but things are definitely a bit more hopeful than in March.

PS. A note to my Chinese readers. If any of you live in Beijing, and can write in English, I hope you can add a comment to this post (I can’t read the Chinese one.) I have two questions:

1. To what extent does the recent upswing in China reflect productive investments, as opposed to wasteful projects that may someday create bad loans for Chinese banks. (Actually, any Chinese reader can answer this one.)

2. I will be in Beijing during the last few weeks of August and first few weeks of September. Any ideas on what to do? I have seen most of the big historical sites on earlier visits to Beijing, and am interested more in new things that may have sprung up since my last visit in 2006. (Restaurants, art districts, interesting new architecture, music and entertainment, etc.) I also will spend a day in Tianjin. Thank you.

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