Defending a Currency Jude Wanniski August 22, 1997

Supply-Side Summer School Economics Lesson #10

Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Defending a currency

Because of the continued turmoil in the currency markets of SE Asia, we have been bombarded with questions both from students and clients about defending a currency’s peg to another currency or to gold. The news this week that Thailand’s trading partners have gathered $18 billion to help it defend the baht -- including, perhaps, a $250 million contribution from our Treasury’s Exchange Stabilization Fund -- has prompted many confused comments. So has the speculative run on the Hong Kong dollar, which was repulsed by a verbal defense from Beijing, which said it was prepared to use its gigantic hoard of hard currency -- $126 billion at last count -- in its defense.

Almost everyone who writes about the topic, not to mention those in charge of policy, make errors large and small because they do not seem to realize that a nation’s currency is part of its non-interest bearing debt. I repeat: Almost every country in this modern world uses as its “money” its non-interest bearing national debt. Panama is an example of a country that decided to use the United States currency as its national money, in which Panamanian national debt is denominated. The United States issues 30-year bonds, 10-year bonds, 5-year notes, 1-year notes, 6-month bills and 3-month bills. The Federal Reserve monetizes this interest-bearing debt by buying it with money it is authorized by Congress to create out of thin air. It simply writes a check in the amount of $10 million or $100 million to commercial banks who belong to the system. The banks surrender the bonds they hold as reserves against deposits and now hold liquid money, which they lend to borrowers, who themselves make bank deposits, against which more loans are made. Some of the bank’s liquidity is used to buy paper currency from the Treasury, which actually prints the stuff. Thus, some of the U.S. government’s non-interest bearing debt is in currency and some in liquid bank reserves that are merely entries on their books.

Now this is all basic, mechanical stuff, but if you forget that what the Fed is supposed to do is manage the amount of debt that pays interest in relation to the amount that does not, you get off the trail about how you defend a currency. The Fed has no control over the nation’s debt, which occurs as result of the government’s fiscal decisions. It does have control over how much of the debt pays interest, which it is supposed to do by correctly managing the supply to meet the demand for non-interest bearing debt, i.e., cash and bank reserves. Defend it against what? Against the loss of its value against another asset! If you are the Thai government, you first have to ask if you want to hold the baht’s value against the dollar. Maybe you did yesterday, but not today. If you decide you want to, how do you defend the Thai baht against losing its value against the dollar when the baht is being attacked -- sold short -- by speculators internal and/or external? That’s what we shall focus upon today.

First, to demonstrate how much confusion there exists in the market for information, I refer you to two editorials written in The Wall Street Journal this week. There are no names attached, but the one written Tuesday August 19, “The Clouds of August,” is smartly done. “On Hong Kong’s Ramparts,” written two days later on August 21, has some confusions. They were obviously written by two different people. We also cite a true abomination that appeared this week in Microsoft’s Slate magazine on the Internet, “Bahtulism: Who Poisoned Asia’s Currency Markets?” written by Paul Krugman of MIT, who is Slate’s chief economist. He is also a man we regularly cite in our list of the Ten Most Dangerous Men in the World, because he gets so much attention from the Establishment press, which believes he is brilliant, but who knows almost nothing about how markets function outside of the textbooks he has mastered. Let’s take Krugman first, with an excerpt from his baht discourse, which you should read in its entirety on Slate.

Currency crises often provoke hysterical reactions in government officials. One day your country's economy is humming along nicely, your bonds are triple-A, you have billions of dollars in foreign exchange reserves socked away. Then all of a sudden the reserves are depleted, nobody will buy your paper, and you can only keep money in the country by raising interest rates to recession_inducing levels. How can things go wrong so fast?

The standard response of economists is that to blame the financial markets in such a situation is to shoot the messenger, that a crisis is simply the market's way of telling a government that its policies aren't sustainable. You may wonder at the abruptness with which that message is delivered. But that, says the canonical model, is simply part of the logic of the situation.

To see why, forget about currencies for a minute, and imagine a government trying to stabilize the price of some commodity, such as gold. The government can do this, at least for a while, if it starts with a sufficiently large stockpile of the stuff: All it has to do is sell some of its hoard whenever the price threatens to rise above the target level.

Now suppose that this stockpile is gradually dwindling, so that far-sighted speculators can foresee the day -- perhaps many years distant -- when it will be exhausted. They will realize that this offers them an opportunity. Once the government has exhausted its stockpile, it can no longer stabilize the price -- which will therefore shoot up. All they have to do, then, is buy some of the stuff a little while before the reserves are gone, then resell it at a large capital gain.

But these speculative purchases of gold or whatever will accelerate the exhaustion of the stockpile, bringing the day of reckoning closer. So the smart speculators will try to get ahead of the crowd, buying earlier -- and thereby running down the stocks even sooner, leading to still earlier purchases. The result is that, while the government's stockpile may decline only gradually for a long time, when it falls below some critical point, all hell suddenly -- and predictably -- breaks loose (as actually happened in the gold market in 1969)...

It is also true that the long-term sustainability of a country's policies is to some extent a matter of opinion -- and that policies that might have worked out, given time, may be abandoned in the face of market pressures. This leads to the possibility of self-fulfilling prophecies -- for example, a competent finance minister may be fired because of a currency crisis and the irresponsible policies of his successor end up ratifying the market's bad opinion of the country... Does this mean that there is no defense against speculative attack? Not at all. In fact, there are two very effective ways to prevent runs on your currency. One -- call it the "benign neglect" strategy -- is simply to deny speculators a fixed target. Speculators can't make an easy profit betting against the U.S. dollar, because the U.S. government doesn't try to defend any particular exchange rate -- which means that any obvious downside risk is already reflected in the price, and on any given day the dollar is as likely to go up as down. The other -- call it the "Caesar's wife" strategy -- is to make very sure that your commitment to a particular exchange rate is credible. Nobody attacks the guilder, because the Dutch clearly have both the capability and the intention of keeping it pegged to the German mark.

Oh yes, there is also a third option. You can erect elaborate regulations to keep people from moving money out of your country. Of course, if investors know that it will be hard to get money out, they will be reluctant to put it in to begin with. There is a case to be made -- an unfashionable case, but not a totally crazy one -- that it is worth forgoing the benefits of capital inflows in order to avoid the risk of capital outflows...

I often run into people who assert confidently that massive speculative attacks on currencies like the ones on the British pound in 1992, the Mexican peso in 1994-1995, and the Thai baht in 1997, prove that we are in a new world in which computerized trading, satellite hookups, and all that mean that old economic rules, and conventional economic theory, no longer apply. (One physicist insisted that the economy has "gone nonlinear," and is now governed by chaos theory.) But the truth is that currency crises are old hat. The travails of the French franc in the '20s were thoroughly modern, and the speculative attacks that brought down the Bretton Woods system of exchange rates in the early '70s were almost as big, compared with the size of the economies involved, as the biggest recent blowouts. Currency crises have been a favorite topic of international financial economists ever since the 1970s. In fact, they are among my favorite topics -- after all, I helped found the field.

First, you should know that two years ago, Paul Krugman visited Thailand on a tour of SE Asia, during which he spread the “unfashionable” message, as he put it above, that “it is worth forgoing the benefits of capital inflows in order to avoid the risk of capital outflows.” This is an argument that was concocted after the Mexican peso devaluation of December 1994, by those who had engineered the devaluation. It held that the enormous capital outflow that followed would not have been possible if the original capital inflow had been restricted to collateralized bank loans. All that “hot” equity money flowing in when the government was following supply-side policies would flow out if it changed policies. As it happened, Polyconomics advised its Global 2000 clients that this was a poisonous message. The Thai government did not listen. On February 28, 1996, we reported:

Thailand’s economic growth prospects are being hindered by the pernicious ideas planted in Bangkok last year during the visit of MIT’s Paul Krugman. He who persuaded the country’s gullible political leadership to avoid Mexico’s fate by blocking the inflow of short-term capital... Government interference in capital flows is discouraging the investment community. Thailand’s bourse has gained 0.9% in dollar terms thus far this year, while those of neighboring Indonesia and Malaysia have risen 15% and 9% respectively. Instead of a focus on growth incentives, Krugman’s visit left policymakers more concerned with combating the current account deficit. He erroneously cited that Mexico’s crisis was caused by the short-term financing of its trade deficit, when in fact it was caused by Krugman’s Ivy League friends in the international banking community.

If you now go back and read Krugman’s three ways to defend a currency, you will note that he does cite a cost to a country for restricting a capital inflow. “Of course, if investors know that it will be hard to get money out, they will be reluctant to put it in to begin with.”  When Krugman now asks: “Who poisoned Asia’s currency markets?” there is no doubt in our minds that it was his poison that began the process. Yes, the dollar deflation of the gold price that also pulled down the baht, which was pegged to the dollar, deflated the Bangkok real estate market and crippled the banking system. But if it had not been weakened by Krugman’s bhatulism, it could have survived. Instead, its neighbors now have to pool their resources to bail it out. Because the International Monetary Fund is insisting upon increased taxes in Thailand, the process of digging itself out of the mess may take even longer than in Mexico.

Notice that in his three methods of defense, Krugman does not mention monetary policy at all. He does not say a currency can be defended by raising interest rates. More particularly, he does not say that a currency under attack for being overvalued can be defended by decreasing its supply -- by having the central bank sell interest-bearing debt for non-interest bearing debt. As far as Krugman is concerned, if you are on a gold standard, you can only defend your currency as long as your hoard of gold holds out. If you are on a dollar standard, you can only defend your currency as long as your dollar monetary reserves hold out. It never occurs to him that the central bank can defend its currency, which it has created by buying bonds with money created out of thin air, by reversing the process -- by selling bonds and putting the liquidity back into thin air.

When Mexico in 1994 sustained speculative attacks on the peso, including the recommendations of Ivy League economists who insisted the peso was overvalued, the Bank of Mexico steadily ran down the huge hoard of dollar monetary reserves it had accumulated between 1989 and 1994. As the Clinton Treasury joined the IMF and Fed bureaucrats in urging the Mexican government to devalue, the crisis became serious only when the Mexican government changed hands on December 1. The dollar hoard of Treasury bonds had melted down to $10 billion from several times that amount a year earlier. Sadly, under operating procedures dictated by the Treasury, the Bank of Mexico continued to buy peso bonds with newly created pesos as fast as it was mopping up the old ones with dollars. The currency cannot be defended as long as the central bank is unwilling to substitute interest-bearing debt for the currency debt that pays no interest. If tax rates are cut in a way that causes an increase in the demand for the national currency, the surplus liquidity can be solved in that fashion -- as we pointed out in Lesson 7 this summer session.

So too with gold. The Federal Reserve has no authority to buy or sell gold, but it has authority to buy or sell U.S. government bonds. Somehow it never occurs to Krugman, and all those academic economists who learn from the same textbook, that if gold reserves are dwindling at Treasury and the government is beginning to look at zero reserves, it need only sell dollar bonds to the banks for cash. As long as the Fed extinguishes the liquid cash asset, or at least buys gold with the cash upon instructions from Treasury, there will be no zeroing out of reserves. This is a far more preferable method of defending a currency than by raising interest rates, although the act of selling bonds for cash may raise rates anyway. Adding or subtracting liquidity directly in order to maintain a dollar peg -- or for the dollar to maintain a gold peg -- should be done straightaway rather than by a circuitous raising of interest rates.

Krugman can not seem to understand any of this, but what about The Wall Street Journal? On August 19, in its editorial arguing against a Fed tightening, one argument it used involved the Thailand example. Probably written by Robert L. Bartley, the editor of the editorial page, here is how it was put:

The value of the baht relative to the dollar is determined by the supply of each. “Intervention” by central banks is typically “sterilized” to leave the supply of baht (or whatever) unchanged, so it of course never works. Yet devaluation is never inevitable in a technical sense; there is always the alternative of slowing the production of baht at the expense of higher interest rates. The political pain can only be increased if the Fed tightens and slows the growth of dollars.

Indeed, Fed policy is the primary determinant of liquidity throughout the world, and in this context there is a case to be made that it has been too tight -- despite the clear overwhelming leveraging of the Thai banking system and soaring U.S. stocks. Widespread devaluations suggest some of the world clients need more breathing room. And of course, the devaluations took place in the context of a falling price of gold, another monetary indicator. Declining wholesale prices similarly suggest that inflation-fighters may even be on the brink of overdoing it.

The only fault we find with these remarks is the assumption that a slower production of baht would automatically mean higher interest rates. This was the argument used in Mexico by our Treasury officials, particularly Deputy Secretary Larry Summers. If we encouraged the Bank of Mexico to extinguish pesos with peso bonds, he told members of the Senate Banking Committee, interest rates would rise! Well, the pesos were not extinguished and interest rates rose from the 20% range to the 60% range. Whoops. In hindsight, Summers told the same members, maybe the pesos should have been extinguished. What I mean to say is that there are times when interest rates climb because of the risk of a currency devaluation, and when the correct defense is deployed, including a shrinking of the central bank’s balance sheet, interest rates will decline. Bartley I think understands this argument, and accepts it, I think, but did not make it clear.

The second WSJournal editorial, August 22, was clearly written by a different person or a committee, not Bartley. It notes the speculative raid on the Hong Kong dollar during the week, and how the raid was thwarted by a “first line of defense,” the monetary reserves of Hong Kong ($67 billion) and China ($126 billion). In fact, the raid ended when Beijing said it would use its reserves to back up Hong Kong’s. The editorial goes on to say:

But even gigantic sums in reserve are not a foolproof defense. Speculators know that Hong Kong’s M2 money supply, including cash and bank reserves, is roughly $200 billion, even larger than the Hong Kong and Chinese reserves combined. Should they succeed in sparking a stampede, local residents would then undermine the fortress from within by switching their local bank deposits into U.S. dollars.

This is nonsense. As the previous paragraph points out, Hong Kong has a currency board regime, which requires that for every $7.80 in Hong Kong dollars created by the banking system, $1 in hard currency must be held in reserves. This means that the $67 billion in U.S. assets held in reserve by Hong Kong will cover all the outstanding Hong Kong dollars. For the editorial’s author to cite $200 billion in M2 as exceeding the combined reserves of Hong Kong and China indicates a misunderstanding of how the banking system works. For every $7.80 in Hong Kong dollars extinguished by the use of $1 in U.S., there would be more like $20 in M2 wiped out. The combined reserves of Hong Kong and China could denude Hong Kong of every Hong Kong dollar three times over. It is inconceivable that a situation would arise in which local residents would feel their deposits threatened, unless they sensed a devaluation was purposely afoot.

The only time a draining of bank reserves in order to defend a currency will actually cause a recession is when the currency is pegged to another currency that is being mismanaged. This happened, for example, when Chile tried bravely to keep its currency tied to the dollar when the Fed was deflating the dollar. Otherwise, broadly speaking, if the peg is to a stable dollar, a draining of reserves will “cause” a recession only when fiscal policy has been mismanaged. That is, a tax or tariff increase that is ill-conceived -- or meant to serve vested interests rather than legitimate general interests -- will always cause a decline in the demand for a country’s liquid bank reserves. They will also cause a recession, or as in the case of the 1929 Smoot-Hawley Tariff Act and the Hoover income tax increases that followed, a Great Depression. To this day, monetarists and Keynesian blame the Great Depression on either the Federal Reserve or the gold standard, for not preventing the sharp decline in liquidity that followed the tariff and tax increases. By keeping the dollar/gold peg at $20.67, the Fed prevented the massive fiscal deflation from being offset with a massive monetary inflation.

I can’t see how this would have done anything but replace the Great Depression with a Great Stagflation, which is what we have just come through these past 30 years. When Roosevelt did lift the gold price to $35 in 1934, on the advice of monetarists who thought it would help, it only caused an increase in the general price level, helping debtors over creditors at the margin, but of course the government itself was a major debtor. The gold value of government debt held by the people who had purchased it declined by 67%, which meant the government shifted a burden from its own shoulders to the population at large. The rise in the general price level that followed the change in the gold price also began the process of bracket creep up the progressive tax schedules.

The best defense of a currency will differ in every situation, at least until the United States takes on the global responsibility of first fixing the dollar to gold. Once all other countries can then fix to the dollar/gold unit of account, they will always be able to find their currency weakness in mismanaged tax, trade or regulatory policies.

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STUDENTS: A major publication has expressed interest in doing a story on Supply-Side University, which would increase the student body considerably and perhaps attract a higher quality of guest faculty willing to do this kind of thing pro bono. The publication has asked why the registered students have done so, what they think they are getting out of this unusual experience, and any other comments they might wish to contribute. You would have to agree to have your comments quoted by name. Please do me and the school a favor and write a sentence or two which we would make available to the press.