Sovereign Currency and Government Policy in an Open Economy

By L. Randall Wray

Government policy and the open economy. A government deficit can contribute to a current account deficit if the budget deficit raises aggregate demand, resulting in rising imports. The government can even contribute directly to a current account deficit by purchasing foreign output. A current account deficit means the rest of the world is accumulating claims on the domestic private sector and/or the government. This is recorded as a “capital inflow”. Exchange rate pressure might arise from a continual current account deficit.

While the usual assumption is that current account deficits lead more-or-less directly to currency depreciation, the evidence for this effect is not clear-cut. Still, that is the usual fear—so let us presume that such pressure does arise.

Implications of this depend on the currency regime. According to the well-known trilemma, government can choose only two out of the following three: independent domestic policy (usually described as an interest rate peg), fixed exchange rate, and free capital flows. A country that floats its exchange rate can enjoy domestic policy independence and free capital flows. A country that pegs its exchange rate must choose to regulate capital flows or must abandon domestic policy independence. If a country wants to be able to use domestic policy to achieve full employment (through, for example, interest rate policy and by running budget deficits), and if this results in a current account deficit, then it must either control capital flows or it must drop its exchange rate peg.

Floating the exchange rate thus gives more policy space. Capital controls offer an alternative method of protecting an exchange rate while pursuing domestic policy independence.

Obviously, such policies must be left up to the political process—but policy-makers should recognize accounting identities and trilemmas. Most countries will not be able to simultaneously pursue domestic full employment, a fixed exchange rate, and free capital flows. The exception is a country that maintains a sustained current account surplus—such as several Asian nations. Because they have a steady inflow of foreign currency reserves, they are able to maintain an exchange rate peg even while pursuing domestic policy independence and (if they desire) free capital flows.

In practice, many of the trade surplus nations have not freed their capital markets. By controlling capital markets and running trade surpluses, they are able to accumulate a huge “cushion” of international reserves to protect their fixed exchange rate. To some extent, this was a reaction to the exchange rate crisis suffered by the “Asian Tigers”—when foreign exchange markets lost confidence that they could maintain their pegs because their foreign currency reserves were too small. The lesson learned was that massive reserves are necessary to fend off speculators.

Do floating rates eliminate “imbalances”? In the global economy, every trade surplus must be offset by a trade deficit. The counterpart to the accumulation of foreign currency reserves is accumulation of indebtedness by the current account deficit nations. This can create what is called a deflationary bias to the global economy. Countries desiring to maintain a trade surplus will keep domestic demand in check in order to prevent rising wages and prices that could make their products less competitive in international markets.

At the same time, countries with trade deficits might cut domestic demand to push down wages and prices in order to reduce imports and increase exports. With both importers and exporters attempting to keep demand low, the result is insufficient demand globally to operate at full employment (of labor and plant and equipment). Even worse, such competitive pressure can produce trade wars—nations promoting their own exports and trying to keep out imports. This is the downside to international trade, and it is made worse to the extent that nations try to peg exchange rates.

Some economists (notably, Milton Friedman) had argued in the 1960s that floating exchange rates would eliminate trade “imbalances”—each nation’s exchange rate would adjust to move it toward a current account balance. When the Bretton Woods system of fixed exchange rates collapsed in the early 1970s, much of the developed world did move to floating rates—and yet current accounts did not move to balance (indeed, “imbalances” increased).

The reason is because those economists who had believed that exchange rates adjust to eliminate current account surpluses and deficits had not taken into account that an “imbalance” is not necessarily out of balance. As discussed previously, a country can run a current account deficit so long as the rest of the world wants to accumulate its IOUs. The country’s capital account surplus “balances” its current account deficit.

It is thus misleading to call a current account deficit an “imbalance”—by definition, it is “balanced” by the capital account flows. As discussed earlier, it “takes two to tango”: a nation cannot run a current account deficit unless someone wants to hold its IOUs. We can even view the current account deficit as resulting from a rest of world desire to accumulate net savings in the form of claims on the country.

Currency regimes and policy space: conclusion.

Let us quickly review the connection between choice of exchange rate regime and the degree of domestic policy independence accorded, from most to least:

*Floating rate, sovereign currency à most policy space; government can “afford” anything for sale in its own currency. No default risk in its own currency. Inflation and currency depreciation are possible outcomes if government spends too much.

*Managed float, sovereign currency à less policy space; government can “afford” anything for sale in its own currency, but must be wary of effects on its exchange rate since policy could generate pressure that would move the currency outside the desired exchange rate range.

*Pegged exchange rate, sovereign currency à least policy space of these options; government can “afford” anything for sale in its own currency, but must maintain sufficient foreign currency reserves to maintain its peg. Depending on the circumstances, this can severely constrain domestic policy space. Loss of reserves can lead to an outright default on its commitment to convert at the fixed exchange rate.

The details of government operations discussed throughout this part of the book apply in all three regimes: government spends by crediting bank accounts, taxes by debiting them, and sells bonds to offer an interest earning alternative to reserves. Yet, ability to use these operations to achieve domestic policy goals differ by exchange rate regime.

On a pegged currency, government can spend more so long as someone is willing to sell something for the domestic currency, but it might not be willing to do so because of feared exchange rate effects (for example, due to loss of foreign currency reserves through imports).

To be sure, even a country that adopts a floating rate might constrain domestic policy to avoid currency pressures. But the government operating with a pegged exchange rate can actually be forced to default on that commitment, while the government with a floating rate or a managed float cannot be forced to default.

The constraints are thus tighter on the pegged regime because anything that triggers concern about its ability to convert at the pegged rate automatically generates fear of default (they amount to the same thing). The fear can lead to credit downgrades, raising interest rates and making it more costly to service debt. All externally-held government debt is effectively a claim on foreign currency reserves in the case of a convertible currency (where government promises to convert at a fixed exchange rate). If concern about ability to convert arises, then only 100% reserves against the debt guarantees there is no default risk. (Domestic claims on government might not have the same implication since government has some control over domestic residents—it could, for example, raise taxes and insist on payment only in the domestic currency.)

Next week: what happens if a country adopts a foreign currency? (Hint: look at the PIIGS!)