Category Archives: inflation

Demonetization on Five Continents

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Several countries are undergoing “demonetization” or currency reforms in which the government recalls bills of particular denomination that are circulation and replaces them with new notes. Some of these initiatives are going better than others.

India is still reeling from the consequences of Prime Minister Modi’s announcement on November 8 that 500- and 1000-rupee denomination bills, which constitute 86 % of the cash in circulation, could no longer be used and that residents have until the end of December to turn them in. They have been waiting in long lines, only to find in many cases that the banks have not received enough of the new currency to make the exchange. Some businesses are unable to operate. India’s experiment is unique in that it combines mostly benign motives – a crackdown on illegal activities – with an abrupt implementation that has inflicted unnecessarily high costs on the economy.

Demonetizations fall into several widely different categories. The most dramatic and disruptive episodes are usually signposts on the highway to hyperinflation. Venezuela’s President Maduro on December 11 announced a recall of the 100-bolivar note, creating chaos by giving residents only 10 days to make the exchange into new higher-denomination-notes (500-bolivar notes and higher, up to 20,000 bolivars).

Venezuela will almost certainly be in hyperinflation in 2017. Economists generally define hyperinflation as a pattern of price rises that exceed 50% per month. The inflation rate may cross over the line into technical hyperinflation within the next few months. Hyperinflation had become much rarer in the 21st century, compared to the 20th century. Venezuela’s would be the first since Zimbabwe’s hyperinflation in 2008-09 — which exceeded 79,600,000,000 % per month, rendering the Zim dollar worthless long before it was officially demonetized.

The current Venezuelan episode continues in a long tradition of gross mismanagement of their currencies by some governments, especially in Latin America and the former Soviet bloc. They have demonetized as a means of confiscating wealth from the public, in effect, and transferring it to themselves. The fundamental problem is that the government spends way beyond its means, unable to finance the spending by taxation or borrowing, and so relies on debasing the currency. The “currency reform” may be announced in the name of a program to end high inflation. But true macroeconomic reform requires fundamental measures to end the excessive printing of money and its origin in excessive primary budget deficits. Without such a true reform, the exchange of new bills for old is just one more symptom of mismanagement (along with price controls and the rationing of goods).

A very different category of demonetization entails the orderly decommissioning and replacement of bills for technical reasons. The technical reasons can range from the lack of popularity of a particular note, to the desire to honor a national hero, to a re-design of features to block counterfeiting, to more consequential – but still orderly – reforms such as a European country’s switch-over to the euro as the national currency. An example was the announcement in April by US Treasury Secretary Jack Lew that the $5, $10 and $20 bills are to be replaced with new designs that include women and civil rights leaders.

What differentiates this second category is that citizens are given enough time to trade in their old currency for the new unit. The monetary authorities plan ahead, so that they have plenty of new bills available. Nobody needs to lose out or even to wait in long lines at the bank. Lithuania is the most recent country to have joined the euro, having given up their lita in 2015. The currency transition went smoothly, as it had when the Germans traded in their marks for euros in 2002, the French their francs, and so on with the rest of the 19 countries that have joined the eurozone.

The main motive for India‘s demonetization apparently puts it into a third category, which includes what the US did in 1969, when it announced the phasing out of $500 bills and higher denominations, and what the European Central Bank commendably decided to do in May of this year with its decision to phase out the 500-euro note. In each of these cases, most of the high-denomination notes are used in illegal activities, ranging from tax evasion to corruption to drug trafficking and even terrorism. So the government stops issuing the big bills to avoid facilitating these illegal activities. Such prominent observers as Ken Rogoff, Larry Summers and Peter Sands think the US should do the same with its $100 bill.

In these cases, the phase-out period is typically long — in some cases indefinitely long, until all the existing paper notes wear out on their own. If the leaders are brave, they could set a relatively short time period, of less than a year, after which the note in question is no longer valid, and could ask tough questions of anyone trying to cash in a large quantity of the high-denomination notes. The goal would be to go beyond merely phasing out the facilitation of illegal activities in the future and to strike a strong blow against those who acquired stockpiles by engaging in such activities in the past. The need for bravery arises because some citizens would object strongly, probably ranging from survivalists to grandparents who want to give a crisp new $100 bill to a grandchild for a special occasion.

Although the discouragement of illegal activities is a motive to be applauded, the implementation in the case of India has obviously fallen short. The reform did not need be so very sudden and so very secret. Especially because the notes were relatively small (worth approximately $7 and $15, respectively) and widely used by all Indians, not just in illegal activities, the authorities should have allowed enough time to print plenty of the new notes and even to allow businesses to accomplish some of the desired switch-over to non-cash means of payment (checking accounts and electronic funds transfer).

Even with the advance warning time, those who had accumulated large wealth stashes in the form of the bills would still have lost some value – in effect a tax – if they had been unable to demonstrate to a bank that they had valid reasons for having the bills. Yes, they would still have been able to take recourse to an unofficial market in the phased-out bills, but they would have had to sell the bills at a discount. Most importantly, allowing more time would have avoided the serious inconveniencing of ordinary people and disruption to the economy that India has experienced since November.

Given the problems that it has created for ordinary Indians, why did the Modi government feel the need to launch the reform so suddenly, without time to print enough new notes? One theory is that a goal was to disrupt rival parties that use cash heavily in their campaigns, ahead of important elections in early 2017 (in the state of Uttar Pradesh). If the theory is valid, it is hardly an uplifting justification for what is supposed to be a good-government reform.

Western leaders probably do not act with sufficient boldness and bravery when they choose to phase out big bills as gradually as they do. But Prime Minister Modi acted too boldly in ending the use of medium-sized bills so abruptly.

[A shorter version of this column appeared at Project Syndicate. Comments can be posted there or at the Econbrowser site.]

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The ECB’s Unprecedented Monetary Stimulus

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After the recent Draghi press conference announcing new measures to ease monetary policy in euroland, I responded to live questions from the Financial Times: “The ECB Eases,” podcast,  FT Hard Currency, June 5, 2014 (including regarding my proposal that the ECB should buy dollar bonds).

And also to questions in writing from El Mercurio, June 5:

• Many critics point that these measures do not solve the economic problems of the Eurozone and in that they only benefit the financial markets. Do you agree?

JF: It is too much to expect monetary policy by itself to solve all the economic problems of the Eurozone. But I think the measures announced by the ECB today were steps in the right direction. Mario Draghi emphasized steps to facilitate the transmission of easier money to the real economy, as part of the Targeted LTROs, and also as part of possible plans for Quantitative Easing in the future.

• The ECB also announced that long term loans will be monitored to assure the liquidity is allocated as new loans to businesses. Is that feasible?

JF: There is no guarantee. It is hard to stimulate increased lending to firms and business fixed investment if firms are not experiencing demand for what they are producing already. The ECB can only try and the Target LTROs look like a good attempt.

• If at the same time the ECB cuts GDP projection for this year and forecasts inflation at 1.4% in 2016, under 2%, is not that a kind of recognition of the limitations of monetary policy?

JF: It is a recognition that the euroland economy has been weaker lately, and inflation lower, than they had hoped.

• Will these measures be enough to boost the recovery? Even when there are still structural problems in the Eurozone?

JF: There are limits to what monetary policy can do, especially when interests are at the Zero Lower Bound, as they are. Far more needs to be done in structural reforms, for example.

• Is it possible that, without the pressure of the markets, the governments of the periphery countries will delay even more the needed reforms?

JF: Any time you use one policy to try to make things better, there is the possibility that it will “take the pressure off” of other policies. But that is not a reason not to do it. And in this case, popular discontent with the long period of economic hardship is so high in Europe — as shown for example by the gains of anti-EU parties in the recent elections — that some positive economic pay-off could arguably help rather than hurt the chances for structural reform.

• The measures of the ECB also imply an intervention in the exchange market. Should we expect measures of other banks in response? Will the pressure over the euro last?

JF: These measures are far short of intervention in the foreign exchange market in the sense of buying dollars for euros. And even if the ECB moves to Quantitative Easing in the future, it is unlikely to adopt my proposal to do it by buying dollar bonds instead of euro bonds. You are wondering about the fact that today’s measures appear so far to have caused a depreciation of the euro (along with some boost to stock markets in Europe, and in some emerging markets as well). I see no reason for other countries necessarily to worry or to respond. Given the chances of higher interest rates soon in the US, I don’t think the current phase is back in the situation of several years ago, when easy monetary policy sent waves of capital into emerging markets and put upward pressure on their currencies. But in any case, the beauty of floating exchange rates is that they can automatically accommodate international differences in monetary policy that arise in respond to differences in each country’s economic needs.

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Considering QE, Mario? Buy US Bonds, Not Eurozone Bonds

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         The ECB should further ease monetary policy.  Inflation at 0.8% across the eurozone is below the target of “close to 2%.”  Unemployment in most countries is still high and their economies weak.  Under current conditions it is hard for the periphery countries to bring their costs the rest of the way back down to internationally competitive levels as they need to do.  If inflation is below 1% euro-wide, then the periphery countries have to suffer painful deflation. 

The question is how the ECB can ease, since short-term interest rates are already close to zero.   Most of the talk in Europe is around proposals for the ECB to undertake Quantitative Easing (QE), following the path of the Fed and the Bank of Japan, expanding the money supply by buying the government bonds of member countries.  This would be a realization of Mario Draghi’s idea of Outright Monetary Transactions, which was announced in August 2012 but never had to be used. 

           QE would present a problem for the ECB that the Fed and other central banks do not face.  The eurozone has no centrally issued and traded Eurobond that the central bank could buy.   (And the time to create such a bond has not yet come.)   That would mean that the ECB would have to buy bonds of member countries, which in turn means taking implicit positions on the creditworthiness of their individual finances.   Germans tend to feel that ECB purchases of bonds issued by Greece and other periphery countries constitute monetary financing of profligate governments and violate the laws under which the ECB was established.  The German Constitutional Court believes that OMTs would exceed the ECBs mandate, though last month it temporarily handed the hot potato to the European Court of Justice.   The legal obstacle is not merely an inconvenience but also represents a valid economic concern with the moral hazard that ECB bailouts present for members’ fiscal policies in the long term.  That moral hazard was among the origins of the Greek crisis in the first place. 

Fortunately, interest rates on the debt of Greece and other periphery countries have come down a lot over the last two years.    Since he took the helm at the ECB, Mario Draghi has brilliantly walked the fine line required for “doing what it takes” to keep the eurozone together.  (After all, there would be little point in preserving pristine principles in the eurozone if the result were that it broke up.  And fiscal austerity by itself was never going to put the periphery countries back on sustainable debt paths.)  At the moment, there is no need to support periphery bonds, especially if it would flirt with unconstitutionality.

        What, then, should the ECB buy, if it is to expand the monetary base?   It should not buy Euro securities, but rather US treasury securities.  In other words, it should go back to intervening in the foreign exchange market.   Here are several reasons why.   

First, it solves the problem of what to buy without raising legal obstacles.  Operations in the foreign exchange market are well within the remit of the ECB.    Second, they also do not pose moral hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy).

Third, ECB purchases of dollars would help push the foreign exchange value of the euro down against the dollar.  Such foreign exchange operations among G-7 central banks have fallen into disuse in recent years, in part because of the theory that they don’t affect exchange rates except when they change money supplies. There is some evidence that even sterilized intervention can be effective, including for the euro.  But in any case we are talking here about an ECB purchase of dollars that would change the euro money supply.  The increased supply of euros would naturally lower their foreign exchange value. 

Monetary expansion that depreciates the currency is effective.  It is more effective than monetary expansion that does not, especially when, as at present, there is very little scope for pushing short-term interest rates much lower.

Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and bringing their export sectors back to health.  Of course they would devalue on their own, if they had not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt).   Depreciation of the euro bloc as a whole is the answer.

The strength of the euro has held up remarkably during the four years of crisis.  Indeed the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting.  The euro could afford to weaken substantially.  Even Germans might warm up to easy money if it meant more exports rather than less.

        Central banks should and do choose their monetary policies primarily to serve the interests of their own economies.  The interests of those who live in other parts of the world come second.  But proposals to coordinate policies internationally for mutual benefit are reasonable.   Raghuram Rajan, head of the Reserve Bank of India, has recently called for the central banks in industrialized countries to take the interests of emerging markets into account by coordinating internationally.  

How would ECB foreign exchange intervention fare by the lights of G20 cooperation?  Very well.  This year the emerging markets are worried about tightening of global monetary policy.  The fears are no longer monetary loosening as in the “Currency Wars” talk of three years ago.  As the Fed tapers back on its purchases of US treasury securities, it is a perfect time for the ECB to step in and buy some itself.


         Jeffrey Anderson and Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Feb. 13, 2014.
         Kathryn Dominguez and Jeffrey Frankel, 1993, Does Foreign Exchange Intervention Work? (Institute for International Economics, Washington, D.C.).
         —“Does Foreign Exchange Intervention Matter? The Portfolio Effect,”1993, American Economic Review 83, no. 5, December, 1356-69. 
         Rasmus Fatum and Michael Hutchison, 2002,  “ECB Foreign Exchange Intervention and the Euro: Institutional Framework, News, and Intervention,” Open Economies Review, 13, issue 4, 413-425.
         Marcel Fratzscher, 2004, “Exchange Rate Policy Strategies in G3 Economies,” in C. Fred Bergsten, John Williamson, eds., Dollar Adjustment: How Far? Against What?  (Institute for International Economics, Washington, DC).
         Stefan Reitz and Mark P. Taylor, 2008, “The Coordination Channel of Foreign Exchange Intervention: A Nonlinear Microstructural Analysis,” European Economic Review, vol. 52, issue 1, January, 55-76.
         Lucio Sarno and Mark P. Taylor, 2001, “Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?” Journal of Economic Literature, 39(3), 839-868.

[A shortened version of this column appears as my March Project Syndicate op-ed.  Comments can be posted there.]

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