Say It Again, Sam

I tweeted, early this morning, a piece by Samuel Brittan in today's FT. I quoted:

No so-called banking union will suffice while these imbalances remain

 Which chimes with my own scepticism that banking union is neither necessary nor sufficient to deal with the Eurozone's problems. Now I am fully awake I have second thoughts. Did I fall into a rhetorical trap? Here is what he meant by "these imbalances":

Since the euro was inaugurated in 1999, German unit labour costs have risen by less than a cumulative 13 per cent. During this time, Greek, Spanish and Portuguese labour costs have risen by 20 to 30 per cent, and Italian ones by even more.

Of course, banking union is not meant to deal with the problem of competitiveness diverging between Eurozone countries. You see the trap. It reminds me of a recent article by Ken Rogoff where he argued that Keynesian stimulus to demand would not work in the Eurozone; what was needed was to fix the banks. So fixing the banks will not resolve the competitiveness problem and boosting demand will not fix the banks and, I suppose, sorting competitiveness will not boost demand.

There are in fact three problems in the Eurozone:

• a financial crisis, in which many banks' solvency is questionable;
• a recession caused by a lack of demand; and
• imbalances in competitiveness (by which I mean misaligned real exchange rates).

A solution for one is not the solution to all. Banking union is intended to deal with the financial crisis, not the competitiveness crisis, and boosting demand is meant to deal with the recession. Where Sir Samuel and Mr Rogoff are correct is that solving only one problem is not sufficient as the three issues interact. So we need to stimulate demand and fix the banks and somehow deal with the effects of different rates of inflation in the Eurozone.

In the heading of this blog, I say that Equals, as in equations, will not fear algebra. I actually have in mind an equation to explain each of the problems. When I find the time I will blog on each.

The Pound in Free-Fall

There has been a bit of excitement in the last few days over the fall in the value of sterling. Here is The Sunday Times going over the top in a "news" story:

Experts warn there could be a major slide in sterling with the pound heading to parity with the euro for the first time since the financial crash of 2008-09.

Plenty of others have commented on the benefits of a lower pound, but my thoughts turned elsewhere. What is a reasonable value for the pound against the euro? Britain has experienced higher inflation than the eurozone in recent years and so you would expect the value of sterling to fall relative to the euro.

The OECD produces some figures on purchasing power parity (PPP), which compares the values of currencies in terms of what they can buy. This gives a quick was to estimate the fair value of the exchange rate (at least for the recent past). I have worked the figures to put them on a chart.


Source: OECD, author's calculation

So back in 2005 the PPP rate was 1.32 € per £. This fell rapidly to 1.15 in 2009 and has been at 1.13 € per £ since 2011.

A quick check of the FT shows the market rate is now 1.1655 € per £. So the current market value is probably sightly above the fair value, especially as inflation has continued to be higher in the UK than in the eurozone. The recent slide has in fact brought the market rate closer to reality.

Update: I could do the same for the pound against the dollar. The OECD figures suggests an PPP exchange rate around 1.47 $ per £ in 2011 and 2012. At the bottom of the recent slide the market rate remained above 1.50 $ per £.

Currency Wars and Competitiveness

Today's papers are full of talk of currency wars. The US dollar has fallen. China is accused of holding down the value of the Yuan. Brazil is using taxes to limit flows of hot money pushing up the value of the Real.

Why?

It is all about competitiveness and so we enter another stage on my quest to understand what that means.

If countries can increase their competitiveness by lowering the value of the exchange rate then we are talking about increasing exports and reducing imports. There is a tendency to report countries with a trade surplus, or more broadly a current account surplus, as competitive.

The question is should a lower exchange rate be an aim of economic policy? Should we look to become more competitive by reducing the exchange rate?

The obvious objection is that everyone can not become more competitive at the same time. If everyone tried to devalue 5% then their exchange rates would stay the same.

Globally the sum of all exports equals the sum of all imports. Every trade has an importer and an exporter. Increasing exports in one country increases imports elsewhere. This is why competitive devaluation is often called a beggar-my-neighbour policy.

The danger is that this turns into protectionism, reducing global trade and the benefits which that brings. Which happens to be one of the reasons why Krugman, in the article I quoted before, calls competitiveness a dangerous obsession.

What is happening right now is that there is not enough demand and so countries try to add to demand through increasing net exports, which amounts to taking demand away from other countries. What the world really needs is an increase in demand overall.

Economics or B*ll*cks?

The pound has risen to a four-month high against the euro, after higher than expected UK inflation raised the prospect of interest rate rises, says the BBC.

Is that economics or is it bollocks?

Yes you are right. In economics higher inflation pushes a currency down not up. I previously told a little story to explain why that is. So why is the BBC talking bollocks?

Well inflation figures were higher yesterday and the pound did rise against the euro so perhaps lazy journalism put the two together. Coincidence doesn't mean one thing caused the other. In fact the euro fell against the dollar as well, so maybe the pound's rise has more to do with the economic news from euroland where Greece seems to be struggling at present.

Perhaps currency traders do care more about interest rates than economic fundamentals and so they did push up the pound as the story says. It is possible; day-to-day market movements are not explicable by economists. On the other hand, the rise in inflation is a blip caused by unusually low prices a year ago. The bank is not about to raise interest rates. Surely, even currency traders can work that out.

Update 20h00

Now the BBC says:
Euro falls against dollar and pound
The euro has hit a five-month low against the dollar as continuing concerns about the Greek economy weigh heavily on the currency.

That is a little more plausible. Incidentaly the latest inflation figures for euroland are up....

BBC Churnalism

Churnalism (n) - the practice of turning a press release into published copy without ever going through the journalist's brain.

Here is another example from the BBC: Pound hit by falling UK inflation. The BBC tries to link the fall in inflation with the fall in sterling, as if the first has caused the second.

"This is bad news for the pound," Duncan Higgins, senior analyst at Caxton FX, is quoted as saying. "The CPI figures will weigh heavily on the UK currency and will continue to discourage investment."

Anyone who has ever opened an economics textbook knows that low inflation, relative to inflation elsewhere, tends to push up the currency.

It works like this. Imagine there are just two currencies, pounds used in Britain and FX used in RoW. If inflation is 1% in Britain and 3% in RoW then 100 pounds will be worth 99 pounds next year while 100FX will be worth 97FX (roughly). So 1 pound will be worth more FX next year than now. The pound should rise.

By the way, the falling pound is good news not bad in the current circumstances. It is adding to demand and will help to reduce the current account deficit.

Economic Churnalism

The BBC reports:
The pound has fallen to its lowest level since April against the euro after a warning that UK public debt levels may not be sustainable.

Except, it didn't happen. The pound has fallen against the euro, but the warning about debt levels didn't happen. This is the "warning" as it appears on the BBC News website:

"In its quarterly bulletin, the Bank of England noted that the UK had run current account deficits for more than a decade - sustainable as long as the deficit was offset by foreign investors' purchases of UK financial assets.

" 'But the financial crisis may have led overseas investors to reassess their willingness or ability to purchase sterling assets and thereby finance the UK trade deficit,' the Bank of England said."

So the warning is about financing the trade deficit, not the government deficit and not the accumulated government debt.

There is a link between government deficit and the trade deficit. Government debt, in the form of gilt edged bonds, is one type of "sterling asset" foreign investors can buy. So too are corporate bonds, commercial paper, shares, property and currency.

Government debt is the "story du jour", and linking the fall in the value of the pound to public debt makes for a better article, according to the values of modern churnalism. By trying to fit the real news (a fall in sterling) to the popular narrative (frightening levels of public debt) the BBC has gone off the rails.

Actually, it gets worse if you read the Bank of England bulletin from which the quote is taken. Chapter 3 is a study looking at the causes of recent changes in the exchange rate. The attractiveness of sterling assets to foreign investors is only one of a number of factors which the study says affect the exchange rate. It concludes: "there is substantial uncertainty about the precise role of each factor"

Finally, I am not sure that sterling has fallen. It seems to me that the euro has risen; it is up against the dollar as well. Fog in the channel; continent cut off.