An Asset Price Theory of Exchange Rates

Towards an asset price theory ofexchange rates

Jan Priewe, HTW Berlin – University of Applied Sciences

Kansas City, 26 September 2014

12th International Post Keynesian Conference

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Agenda

1. Where does orthodox exchange rate theory stand?

2. Where does Keynesian exchange rate theory stand?

3. Some new ideas

4. The dollar-euro/DM-exchange rate since 1970

5. Where to go

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1. Where does orthodox exchange rate theory stand?Traditional XR determinants:

st = α Et(yt+1 - yt+1*) + ß Et(PPP* - PPPt) + λ Et(πt+1* - πt+1) + γ Et(rt+1 - rt+1*) + εt

But:„There is overwhelming empirical evidence that the exchange rates of the most important currencies are unrelated to the fundamentals that economic theory has identified.” (De Grauwe 2000, 353)

Most orthodox economists believe in the long-run validity of PPP, admit that in the short-run (1-2 years) deviations from fundamentals occur. They cannot explain the transition from the short-run to the long-run.

Exchange rate theory is one of the Achilles heels of mainstream international macroeconomics.

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2. Where does Keynesian exchange rate theory stand?• Keynes: PPP is „truism“ (1923); Keynes did not develop a coherent XR theory for flexible

XR; speculation not very important for him

• Davidson: uncertainty, unanchored expectations volatility, high XR elasticity ofexpectations, visible hand necessary on forex markets

• Harvey: forex is financial asset; speculation of forex dealers, predominance of chartistsrelative to fundamentalists; high volatility; in the long-run huge imbalances in BoP; cyclicity not addressed

• Kindleberger/Minsky: model of boom-bust cycle of asset prices applicable to forexmarkets

„One place where the model surely applies today is foreign exchange markets, in which prices rise and fall in wide swings, despite sizable interventions in the market by monetary authorities …. “ (Kindleberger, 2000, p. 21)• Behavioral finance (De Grauwe et al.): microeconomic approach; under high uncertainty search for simple heuristics; Chartists predominate against fundamentalists; rejectionof rational expectation theory and efficient market hypotheses; but: „boundedrationality“; rejection of PPP

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3. Some new ideas1.) Role of „fundamentals“ – key point of disagreement

• „Fundamentals“ is umbrella term for many diverse determinants – heterogeneityof fundamentals

• Fundamentals do play a prime role when it comes to reversals from appreciationto depreciation (change of sign)

• Fundamentals often without clear, unambiguous direction

• Indicators on fundamentals require interpretation and policy decision

• Trade-offs among different fundamentals

• „perverted PPP“ can happen: output/employment adjust to misaligned XR, in case over-valued XR industries will shrink or go bust return to PPP impossible

• Natural „trustees“ of fundamentals are/should be central banks/governments

• In most modern analyses: PPP-deviation neglected, although very relevant in exuberant episodes

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2. Predominance of destabilising speculation

• Most of the time: speculation of forex trading industry, algorithm trade(high frequency trade), derivatives abet upward and downward speculation

• Short-termism underscores lack of fundamental ingrediences in traders‘ rules

• Predominance of destabilising speculation (microeconomically „rational“) , lack of stabilising speculation (see Kindleberger/Minsky)

• „rational bubbles“?

• Currencies are special asset class; traders deal mostly on their account, detached from goods trade, portfolio or direct foreign investment

• Financialised forex markets

• Long waves of upward/downward speculation, as long as fundamentalistsare weak or inactive

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3. Boom-bust cycles of appreciation – depreciation• Similar to other asset classes: value of currency does not grow infinitely• Point and time of reversal unpredictable, no clearly defined floors/ceilings• Reversal episodes in the past idiosynchrati• Important fundamentals strongly „violated“• PPP must play a role since trade with goods and services becomes

extremely distorted; heavy pain for strongly appreciating and depreciatingeconomies

• Capital flows also strongly distorted• Risk of recession, balance of payments or financial crisis• Central banks become concerned• Vested interests of many interest groups are at risk• In many reversal episodes of XR, central banks intervened on forex

markets

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4. The dollar-euro/DM-exchange rate since 1970• Since 1970: strong volatility, trend towards nominal appreciation of

DM/euro• Bilateral real exchange rate appreciated at times by > 100%, and

depreciated afterwards excessively• Long-run trend: only little real appreciation of DM/Euro since 1973• Among all fundamental factors, PPP most strongly violated in phases of

extreme misalignments• Problems of measurement of PPP remain (tradables, nontradables; high

transaction costs (Rogoff)?)• Varying deviation of PPP cannot be explained by transaction costs• Europe can only „survive“ the roller-coaster XR by stable intra-European XR• In several recessions, the dollar revalued against DM/euro• Prime reserve currency is more resilient than others (not substitutable),

can live with XR volatility better than others

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50

100

150

200

250

300

350

400in

de

x, 1

97

3 =

10

0

Nominal exchange rates of leading currencies vis à vis US-$, 1950-2013

- Index 1973=100, annual averages -

US-$/DM oder € US-$/Yen US-$/GBP US-$/CHF

DM€

CHF

Yen

GBP

9

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60Ja

n/

99

Au

g/ 9

9

Mrz

/ 0

0

Okt

/ 0

0

Mai

/ 0

1

Dez

/ 0

1

Jul/

02

Feb

/ 0

3

Sep

/ 0

3

Ap

r/ 0

4

No

v/ 0

4

Jun

/ 0

5

Jan

/ 0

6

Au

g/ 0

6

Mrz

/ 0

7

Okt

/ 0

7

Mai

/ 0

8

Dez

/ 0

8

Jul/

09

Feb

/ 1

0

Sep

/ 1

0

Ap

r/ 1

1

No

v/ 1

1

Jun

/ 1

2

Jan

/ 1

3

Au

g/ 1

3

Mrz

/ 1

4

Euro-USD-XR 1999-2014: monthly values and annual values (indirectquotation)

1st of month

10

Annual mean

60

80

100

120

140

160

180

200

220

19

73

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

Nominal and real exchange rate DM/€ for US-dollar and real effective exchange rate 1973-2013

index 1973 = 100 (annual averages, indirect quotation)

real effective XR

nominal XR

bilateral real XR

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0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

Exchange rate USD/DM-€, differential of short-term interest rates anddifferential of current account balance D/EZ-USA) 1992-2013

(until 1998 Germany, then Eurozone)

differential short-term interest rates (D/EZ-US)

differential current account balance (% of GDP), D/EZ-US

USD per DM/€, rhs

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-50

-40

-30

-20

-10

0

10

20

30

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

Four fundamentals and the DM/€/USD exchange rate 1992-2013 (until 1998 Germany, afterwards Eurozone)

diffential inflation (US-D/EZ) differential growth (D/EZ - US)

differential short-term interest rates (D/EZ-US) change of XR (USD per DM/€), rhs

deviation price level from PPP (US-D/EZ), rhs

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0.700.800.901.001.101.201.301.401.501.601.701.801.90

Deviation of PPP of select countries 1990-2013 vis à vis the US (= 1)*

Germany Japan Italy France US GB Switzerland

14

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

1/2

/19

70

1/2

/19

72

1/2

/19

74

1/2

/19

76

1/2

/19

78

1/2

/19

80

1/2

/19

82

1/2

/19

84

1/2

/19

86

1/2

/19

88

1/2

/19

90

1/2

/19

92

1/2

/19

94

1/2

/19

96

1/2

/19

98

1/2

/20

00

1/2

/20

02

1/2

/20

04

1/2

/20

06

1/2

/20

08

1/2

/20

10

1/2

/20

12

1/2

/20

14

US-$ per DM/€ 1970-2014 (daily values, indirect quotation)

1980

1985

1995

2000

2008

1991

DM Euro

1973

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5. Where to go• Recommencment of XR theory necessary• Reconsideration of Keynes‘s endorsement of PPP (for tradables, adjusted

for transaction costs) and on his analysis of uncertainty, expectations andspeculation

• Financialisation of XR in modern flexible rate regimes (unregulatted forexmarkets, full international capital mobility) huge volume of transactions, unrelated to fundamentals

• Destabilising speculation predominates, one-directional• Reversals unavoidable!• In reversal episodes, fundamentals under strong stress• Crises or central bank interventions have plaid certain roles in the past• Turning points still diffficult to explain; econometric methods fail• Strong overlapping of behavioural finance XR theories and Keynesian ideas

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collaboration of two leading CBs and reserve currencies

remember Keynes 1923: dollar and Sterling blocs shouldcooperate, leading to more stable XR worldwide

monetary cooperation Fed/ECB is a cornerstone for global monetary reform

Keynes 1923, p. 204:

„The best we can do, therefore, is to have two managed currencies, sterling and dollars, with as close a collaboration as possible between the aims and methods of the managements.“

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