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MMT and External Constraints

by L. Randall Wray, New Economic Perspectives

To Fix or To Float, that is the question.

MMT argues that a sovereign government that issues its own “nonconvertible” currency cannot become insolvent in terms of its own currency. It cannot be forced into involuntary default on its obligations denominated in its own currency. It can “afford” to buy anything for sale that is priced in its own currency. It might be able to buy things for sale in foreign currency by offering up its own currency in exchange-but that is not certain.

If, instead, it promises to convert its currency at a fixed price to something else (gold, foreign currency) then it might not be able to keep that promise. Insolvency and involuntary default become possible.


Generally speaking, the nonconvertible, floating exchange rate currency system provides more policy space. Government can use fiscal and monetary policy to pursue the domestic agenda. Fixing the currency reduces policy space because government must consider its promise to convert. That can conflict with the domestic policy agenda. For example, it is usually (but not always) the case that the government must pursue policy to ensure a positive flow of foreign currency (or gold) to be accumulated as a reserve to maintain the peg. That usually means domestic unemployment to keep wages and imports down.

So far, this is just logic. Pegging your currency adds a constraint: you need to obtain that-to-which-you-peg in order to ensure you can convert at the pegged price. How binding is the constraint? It depends. In the case of China today, its “managed” exchange rate is not very binding. For example, China has committed to fairly rapid growth of domestic wages. By contrast, in the case of Nepal, the peg against the Indian currency is constraining. If Nepal were to pursue China’s policy of raising wages, her trade deficit with India would grow; unless she could somehow increase remittances from her workers abroad, reserves of Indian currency as well as dollars would be depleted. Her peg would be threatened and a currency crisis would be likely.

Now, would China or Nepal benefit from floating? I have no doubt that China would eventually be in a position where floating would not only be desired, but it would be necessary. China will probably float long before it reaches such a position. China will become too wealthy, too developed, to avoid floating. She will stop net accumulating foreign currency reserves, and will probably begin to run current account deficits. She will gradually relax capital controls. She might never go full-bore Western-style “free market” but she will find it to her advantage to float in order to preserve domestic policy space.

If she did not, she could look forward to a quasi-colonial status, subordinate to the reserve currency issuer. China will not do that.

MMT emphasizes that in “real” terms, imports are a benefit and exports are a cost. Floating the currency and relaxing capital controls allows a nation to enjoy more “benefits” (imports) and fewer “costs” (exports). The nation can “afford” to enjoy all the output it can produce plus whatever output the rest of the world wants to sell to it. It “pays for” those net imports through expansion of its capital account surplus. On the capital account, this is reflected in rest of world accumulation of financial claims denominated in the importer’s currency.

The balances balance. While many say the USA has a “trade imbalance” because the current account is in deficit, there is no imbalance because the capital account is in surplus. Dollar for dollar. There cannot be an imbalance. Foreigners want the dollar assets, and so they sell their output to the USA. Perhaps it is their national interest to do so; perhaps it is not. This is not a matter for me to judge. It is certainly in someone’s interest or they would not do it. Maybe the exporters run policy. Maybe the rich elite do. Or maybe it really is in the national interest.

Brian Romanchuk has a great piece up at his blog: “Why Rich Countries Should Float Their Currencies” (see here). He’s a bond market expert who recognizes that rich, developed countries do not face an “external constraint” so long as they float. I’m not going to repeat his whole argument-you really should read his piece-but here’s the main point: if foreigners want to sell their output to your country, you don’t need to worry about how to get the foreign exchange to finance that.

“There is an accounting relationship that says that foreign entities* have to place financial inflows into a country to match the outflows corresponding to its current account deficit (ignoring small external flows like foreign aid transfers). This seems to imply that foreigners have veto power over a country’s policies, and I have seen arguments that domestics are forced to borrow in foreign currencies as a result of the accounting.

However, the volume of foreign exchange transactions have been found to be an order of magnitude larger than what is needed to support trade flows. This hyperactivity is partially the result of foreign exchange trading, but it also reflects very large gross cross-border capital market flows. These flows determine the relative value of currencies. The ultimate counterparty to an importer is most likely a foreign investor who wishes to run foreign exchange risk; there is no necessity for domestics to have to borrow in foreign currencies to finance imports.

It is very possible that a fall in the currency will make a current account worse (as imports become more expensive, and quantities do not immediately adjust), a point that was made in the comments to my previous article. But since the valuation of currencies are driven by capital flows, not trade flows, this cannot go on forever. The domestic wage bill of exporters is being deflated versus international peers, and they become more competitive. (Imported input prices rise in local currency terms, but they pay the same world prices faced by competitors.) Since the exporters are more competitive, expected future profits rise, making domestic equities relatively more attractive. This effect will eventually limit the weakness of the currency. And the empirical reality is that the developed market currencies move around a lot, there appears to be a limit how far they can deviate from a purchasing-power parity fair value estimate.

Although currency volatility is disruptive, companies can use currency hedges to limit the impact of short-term volatility. In a country like Canada, where currency volatility is expected, business managers have learned the hard way that external currency economic exposures need to be controlled. (For example, the next year’s expected foreign currency revenue may be hedged, giving time to react to forex moves.) Conversely, what we we saw in Asia in 1997 was that businesses had come to rely on central banks stabilising the currency, and they engaged in speculative cross-currency exposures (such as borrowing in U.S. dollars because “interest rates were lower”). To paraphrase Minsky, instability is stabilising.

In any event, I argue that a bid for a developed market currency always exists at some price, because of the potential demand for local currency financial assets. It would require the currency to essentially cease to exist in order for there to be no demand for the currency. This could result from the government repudiating its debt, or regime change (war, revolution). Additionally, it could result from a mass default by the domestic banking system. The latter possibility is very real, and it explains why that it is necessary for regulators to prevent domestic banks from building up foreign currency exposures (as seen in Iceland). This implies that there is a constraint on regulation – banks must be regulated in a fashion that is coherent with a free float in the currency. Many countries have failed to regulate their banks properly (e.g., foreign currency mortgages are commonplace in many countries), but their incompetence does not mean that it is impossible to run a banking system properly.

Under the assumption that there is always a bid for the currency, it will always be possible to finance a current account deficit. The only question is the price at which the financing occurs”.

To put this as succinctly as possible, if you offer US or Canadian or Australian Dollars, or UK Pounds, or Japanese Yen, or Euroland Euros, you will NEVER find a lack of bidders. The only question is over the price. Heck, I’ve offered Mexican Pesos, and Colombian Pesos, and Turkish Lira and many other currencies many times, and never found a lack of bidders.

Brian goes on to admit he’s only talking about the situation of “rich” countries. He says he suspects it is better for the developing countries to float, too, but they face difficult problems that he doesn’t feel he knows enough about.

I’m with Brian on that. Frankly, I do not know if Nepal would do better if it floated. I suspect that for many of the world’s poorest countries, the exchange rate regime is not the central issue-and they are probably screwed whether they fix or they float.

Critics of MMT love to point to such cases as proof that MMT is somehow wrong. They challenge us to find a solution to the problems faced by poor countries. If MMT cannot find a simple solution to the complex problems facing developing nations, then somehow MMT is wrong. It is a most bizarre claim.

All we claim is that with a sovereign, floating currency a government of a developing nation can “afford” to employ all its domestic resources that are willing to work for the domestic currency.

Will such a nation be able to import all that it wants? Probably not. Would pegging the exchange rate allow it to import more? Maybe-but then it is very likely that it will have to give up full employment at home. And it will be subject to insolvency and default risk (because it has promised to deliver something it might not be able to deliver).

Is that a trade-off that is in the domestic interest? I doubt it, but I am not sure.

What I observe out in the real world is that pegged exchange rates in developing countries are usually in the interests of the elites-who like their luxury imports and vacations in NYC and Disneyworld. Typically somewhere around half the population is either unemployed or “casually” employed (washing windshields of the luxury imports at stoplights). Seems like a bad trade-off to me.

The big bogeyman usually raised is “inflation pass-through”. A floating currency opens the possibility of exchange rate depreciation that raises the costs of imports and “passes through” to domestic inflation. As Brian says that inflation impact is usually vastly overstated.

Neil Wilson has a good take on all this, too, in his piece “It’s the Exporters Stupid”:

“The key point is that if a currency moves down so that imports become ‘more expensive’, then the ‘inflation’ that goes off is a distributional response that tries to eliminate some of those imports so that the exchange demands equalise. That also eliminates somebody else’s exports.

The important thing to remember is that when a currency goes down, all the others in the world go up in relation to it and nations that rely upon exports (export led nations) start to lose trade – which depresses their own economy.

Any one of those other economies can intervene in the foreign exchange markets, purchase the ‘spare’ currency and that will halt the slide for everybody. And all exporters to an import nation have a central bank with infinite capacity to do that.

Export-led nations have to constantly provide liquidity into the rest of the world to allow others to buy their goods. Otherwise the rest of the world runs out of the particular money that is needed for the export transaction to complete and the export never happens (UK buyers buy Chinese goods with GBP, but Chinese workers are paid in Yuan. The relative shortage of Yuan due to the export differential has to be provided by the Chinese or Chinese goods become, in absurdum, infinitely expensive).

So the important insight, IMV, is that exporters need to export and the central banks that support that policy with ‘liquidity operations’ will ultimately halt any slide for any important export destination – either explicitly or implicitly through their own banking system….

For me the policy response to sliding currencies is to control the distributional inflation by temporarily banning the import of ‘luxury’ items. That forces the problem onto the exporters, which they can relieve by systemically intervening and fixing the currency imbalance. Forcing them to do what they normally do through the course of trade.”

I agree with Neil that it is better to float and then deal with the pass-through inflation; and it makes sense to force as much of the “pain” of fighting the inflation on the rich as possible. After all, they are the ones importing the BMWs and taking the kids to Disneyworld. As Neil notes in response to Ramanan, I have argued as follows:

“the MMT principles apply to all sovereign countries. Yes, they can have full employment at home. Yes, that could lead to trade deficits. Yes that could (possibly) lead to currency depreciation. Yes that could lead to inflation pass-through. But they have lots of policy options available if they do not like those results. Import controls and capital controls are examples of policy options. Directed employment, directed investment, and targeted development are also policy options.”

I am not flippant about the many real constraints faced by a poor, developing nation. At an early stage of development, imports are very hard to get. The national currency faces little external demand. The world doesn’t want the nation’s produce, so it cannot export. Borrowing foreign currency can easily lead to excessive debt service and financial collapse.

Neither floating nor fixing is going to easily resolve these problems. That MMT does not have an easy solution to them does not, in my view, prove that MMT is flawed. My suspicion is that floating the currency and taking advantage of the sovereign’s ability to spend domestically is a step in the right direction. Capital controls are probably necessary-even more so if the country does not float. Foreign aid is probably necessary to finance needed imports.

Full employment of domestic resources is even more important for the developing nation than it is for the rich, developed nation. And yet what we find is precisely the reverse: unemployment is much higher because the government thinks it cannot “afford” to offer jobs. Hence, MMT can offer useful advice even if it cannot offer a magic wand to wish away all the problems faced by developing nations.

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2 Responses to MMT and External Constraints

  1. Inquisitive says:

    Thanks for a great article.

    My concern is how does the Government debt/private sector savings get unwound in a country like Japan where the population is aging and not growing? What are the expected flows?

  2. Inquisitive  
    Comment submitted by email:
    Why would it ever get unwound?  The government’s debt is a private sector asset.  Should we try to find a way to remove assets from the private sector?  The USA government has been in debt continuously since the founding of the country, save for a very brief period under President Jackson, who managed to “unwind” all the debt and caused our first national economic depression. Indeed, all six of our depressions (including the last one in the 1930s) was preceded by an attempt to “unwind” the government’s debt (and those were our only significant reductions of outstanding debt except for the Clinton years—which also crashed the economy and set us up for the Global Financial Crisis). Coincidence? I think not. The only way that sovereign debt/GDP ratios can fall without damage to the private sector is for GDP to grow faster than debt. That is what usually happens in economic recovery. Japan’s problem is that every time she starts to recover, the government adopts tax hikes that always kill the economy.
    Randy Wray