Tag Archives: currency

(Revised) Electronic Money: Revisited

In class, Professor Kimball has discussed his strong support for the discontinuation of paper money, and for it to be switched to be electronic. He has written countless blog posts about it. One of which is about the zero lower bound, or ZLB. Along with that, he contributed an article to Slate that made connections to bitcoin. Professor Kimball’s main claim about eliminating the ZLB is that negative interest rates are crucial to the economy’s recovery. Negative interest rates will cause increases in investments. The main function of eliminating the ZLB is to decrease the incentive to save, therefore stimulating consumption. Consumption is important for combatting the recession, and a huge increase in consumption would help raise output.

It seems that this idea has been catching on. An article in the Wall Street Journal, discussed the elimination of paper currency as well. However, this was more from a legal standpoint. According to the article, crime has been declining very quickly since the 1990’s. The article mentions that a possible reason why is that people have been using cash less and less. Cash is very anonymous, which means that it is integral to illegal transactions.

To this day, I have been having trouble completely agreeing with Professor Kimball’s stance on the elimination of paper currency. I agree that the ZLB is created by paper currency. I also believe that this idea could work in theory. When interest rates decrease, consumption and investment go up. This is because the interest rate is the opportunity cost of spending money, as opposed to saving it. A lower interest rate means that by spending, the individual is giving up less than he would if the interest rate was higher. The biggest problem for me is that creditors will disappear. Positive interest rates make creditors want to lend money because the borrower will pay back more money in the future. Nobody would want to lend money at a negative interest rate. Why would somebody want to lend money when he or she knows that the borrower will pay back less money in the future?

I do agree with every legal standpoint in this discussion. Electronic money is very easy to trace. A bank, or the government can know when and where a transaction is made. The same cannot be said about paper currency. If paper money were to be eliminated, how would a drug dealer be able to sell his product? Would the buyer pay him with Square? The answer is “no” because the government would be able to see it.

Commodity currency Co-movement

It is financial common sense that oil price and US dollar exchange rate show negative correlation. However, both oil price shock and US dollar could be leading factor in this co-movement. On the one hand, depreciation of US dollar precedes increase of oil price because oil is priced in dollar. For examples, a depreciation of US dollar could encourage global demand for oil due to increasing purchasing power of import countries. It could also lead to oil producer rising oil price to counterbalance the reduced purchasing power of the oil revenue. On the other hand, oil price increase could lead to dollar appreciation. Specifically, to the extend that oil revenues are used to purchase goods and services disproportionately from U.S, or invest disproportionately in the U.S, this recycling of petrodollars could be associate with a stronger dollar.

From research paper of What Drives the Oil-Dollar Correlation? by Christian Grisse form Federal Reserve Bank of New York,  oil price shock is more likely to predict exchange rate within a month, because exchange rate respond more quickly, whereas oil price takes longer to fully adjust. In longer time horizon, say a quarter or a year, dollar exchange rate tend to predict oil price.

Not just for oil, other major commodities typically follow and inverse relationship with the value of the dollar. When the dollar strengthens against other major currencies, the prices of commodities typically drop. When the value of the dollar weakens against other major currencies, the prices of commodities generally move higher.

As you could predict, countries that are major importer of oil tend to have currency negatively correlated with oil price, whereas exporter tend to have currency positively correlated with oil prices. For example, the Canadian dollar and New Zealand dollar, along with some other currencies of nations that rely heavily on the export of raw goods, tend to strengthen with rising oil and natural-gas prices. Japanese yen tend to fall with oil price surge as Japan rely heavily on oil import.

There is a lot of theory regarding exchange rate determination. For high frequency data, exchange rate is affected by various amount of macro-economics news . Therefore when forecasting exchange rate in the short run, it is important to partial out all the aggregate of these effects before looking at the predictability of oil price on exchange rate. For longer term exchange rate determination, all the short term shock will not matter since efficient market will fully adjust exchange rate to long term equilibrium level. 

 

The Story of the Dollar: The Global Hedge

A recent Economist article, “The Once and Future Currency,” discusses some of the claims made in a new book, “The Dollar Trap,” written by Eswar Prasad of Cornell University. Prasad argues that the dollar will remain the reigning reserve currency of the world for years to come due to three main reasons: (1) Foreign attraction to the dollar during financial crises, (2) the size and sophistication of the U.S. economy, and (3) the growing population of pensioners in the U.S.  I’ll elaborate on each of these three points below and then give my own take.

1.    Foreign Attraction to the Dollar During Financial Crises

One would think that after the 2008 financial crisis, the dollar’s strength and future as a foreign reserve currency would be put into question, however, Prasad argues that the crisis actually did the opposite– the crisis cemented the dollar’s importance as a global hedge against foreign currency risk. As the article states:

In the last four months of 2008 America attracted net capital inflows of half a trillion dollars… America’s slump forced the Fed to ease monetary policy dramatically. In response, central banks in emerging economies bought dollars to stop their own currencies rising too fast.

I find that quite surprising. Even when the financial crisis originates in the U.S., the dollar is still used as a safe harbor by foreign central banks.

Another interesting strategy the article brought up– a strategy the Fed actually already used at the end of 2008­– is the creation of currency swap lines between the Fed and other central banks. In these deals, the Fed offers to swap currencies with certain central banks at the current exchange rate under the agreement that the currencies would be swapped back later at the same rate. This allows the Fed to earn interest on the foreign central bank’s loans to domestic banks, but not bear any of the credit risk. The credit risk still lies with the foreign central bank. In its first swap of this kind with South Korea in late 2008, the Fed earned a return of 6.84%.

2.    The Size and Sophistication of the U.S. Economy

Another argument Prasad uses to defend his point about the future strength of the dollar is the combination of size and sophistication that the U.S. economy exhibits. Many argue that China’s currency, the yuan, will overtake the dollar as the main foreign reserve currency, but Prasad asserts that that is unlikely. Although China’s GDP is growing rapidly and is estimated to overtake the U.S. in 2020, China’s debt markets are still not nearly as big or as open as those of the U.S. There are large restrictions on the amount of Chinese debt that foreign investors can own. The fact of the matter is that China’s economy is still playing catch up with the U.S. and it will take many more years before its financial markets exhibit the same depth and variety as the U.S.’s.

Furthermore, due to the growth China has experienced, the yuan has been appreciating rapidly and this is not necessarily attractive from the perspective of a foreign investor:

The dollar’s depreciation over that period is, of course, bad for anyone holding American assets. But the dollar is not merely a store of value. It has also become a popular “funding” currency. Banks and multinational firms borrow in dollars, even as they accumulate assets in other denominations. Since no one wants to borrow in a currency that only goes up, this is not a role that China’s currency could easily play.

3.    America’s Growing Population of Pensioners

Although a growing amount of pensioners is not a good sign for the productivity growth of the U.S. economy, Prasad argues it makes the dollar more attractive globally. Not only do pensioners hold a majority of U.S. debt that is not owned by foreigners, but also, old, wealthy individuals act as a powerful political influence. These individuals will go to great lengths to ensure that the dollar retains a stable value.

I would agree with Prasad that the dollar is unlikely to lose its status of global prominence anytime soon. Even in the wake of a rapidly growing Chinese economy, the dollar still has a number of clear advantages to the yuan that will not dissipate until China’s economy matures.

China Loosens Grip on Yuan

If there is one thing that has been as reliable as the sun rising daily over the course of the last couple of decades, its the fact that China manipulates its currency and that the US follows by deeming China a currency manipulator. Interestingly enough though, this “broken record” type situation may soon be coming to a close.

As China has faced massive problems with liquidity in its deregulated shadow banking sector as well as a credit crunch that has plagued the country recently, concerns about growth and credit stability have taken center stage. (WSJ) Chinese financial leaders seem to now be realizing that steps need to be taken in order to improve their own global financial position and that means taking a look at their currency.

The Chinese have what is referred to as a “pegged currency” — they control or peg their exchange rate to another currency (ie: the USD) in an attempt to make trade easier for all parties involved and keep expectations constant. One of the side effects of a mechanism like this is the weakening of the pegged currency and the loss of the ability control interest rates and money supply — because you constantly have to be able to absorb any increases in supply as well as satisfy any excess demand as well. China does this in order to make their exports cheaper in foreign currency terms. As we have talked about in class, a weaker Yuan leads to more demand for the currency due to cheaper exports, which leads to a higher GDP.

The sustainability of a mechanism like this has always been scrutinized but has never seemed to bother China (and why would it with 10% y/o/y GDP growth) but that seems to be changing before our own eyes. In China’s pegging scheme, the central bank controls the range in which the Yuan/USD is allowed to fluctuate (See the image below)

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This range has been about 1% movement in either direction historically but the central bank is rumored to be preparing to let it broaden to 2 or 3% in either direction. (WSJ) Now while that may not seem like much, it may signify the fact that China is realizing that its economy is changing and is ready to adapt (the call being for a free floating currency eventually). The WSJ article also points out that another motivation for the movement to a free floating currency may be that China’s real goal is to overtake the dollar as the world reserve currency eventually. This seems like something of a pipe dream, but enough people use the Yuan that it might not be out of the question. All in all the loosening of the currency grip will be a good thing for the dollar and the US because it may force outflows to China to stay in state and boost GDP here.

Why Should We Care About Yuan’s Decline

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In the past week, the People’s Bank of China has been guiding the yuan lower against the dollar – by setting a weaker benchmark against which the yuan can trade. It has also intervened in the currency market by directing state-owned Chinese banks to buy dollars. According to Wall Street Journal, China’s central bank engineered the recent decline in the country’s currency to shake out speculators as it prepares to allow a wider trading range for the tightly tethered yuan.

It wasn’t market forces or traders behind the move, but that the Chinese central bank was deliberately pushing the currency lower. For a very long period of time, the yuan was long seen by investors as a currency that was only going up. Why was the Chinese central bank doing this?

Every day, the yuan trades within a tight range set by the central bank every day. However, short-term traders and increasing demand is almost constantly pushing the currency higher within that range. Therefore the central bank is trying to bluff away these traders. In this sense, fewer speculators will trade the yuan, China now hopes to have an easier path to widen the yuan’s trading range further. In the much longer term, this will make the yuan a free-floating currency that’s driven only by economic and market forces. PBOC officials have said in the past that the yuan is nearing its fair-market value, or “equilibrium level,” meaning the chances of any drastic movements in the currency are limited.

I believe that this would be a great step for China – free its currency in the long term. A freer yuan may also help China deflect foreign complaints about its currency policies. The U.S. and other advanced economies have pressed Beijing for years to relax its hold on the yuan, allowing it to rise in value and boost Chinese consumer demand. The free trade of currency will open up a wide door for the yuan to become much more prominent in trade and payments across the globe. More importantly, in my understandings, a freely convertible currency also makes the yuan a more attractive option for other central banks’ stockpiles of cash, also known as their foreign exchange reserves. The current situation is that U.S. dollar dominates the currency market as the number-one reserve currency in the world. This perfectly explained why so many central banks hold U.S. government bonds even when the U.S. economy was in recession.

 

 

 

The Chinese Economy and The World

Today, the Wall Street Journal reported that the Chinese Central Bank engineered the decline of the nation’s currency, the yuan. The central bank did this by setting a weaker trading benchmark  against the yuan, and by having Chinese banks buy dollars.

In his article, Keith Bradsher of the New York Times reports on the rise in Chinese exports despite decline of the economy. Another New York Times writer, Anatole Kaletsky explores the conflicts of interest in the decline of China’s economy. The country is moving towards stronger bank lending, but officials want to reduce credit growth.

All of these can be looked at from a monetary perspective. The decline in the nation’s currency is related to the growth in exports. When a currency is weak, goods and services for the respective country are cheaper to the rest of the world. This will cause an increased demand  for these Chinese goods and services that are cheaper than domestic goods and services in the countries trading with China. Furthermore, when the Chinese currency is cheaper, foreigners will want to buy Chinese assets because they can purchase a lot for a little of their own money. With this increased interest in currency, asset values rise. This means that the people who bought the Chinese assets when it was cheap made money from this appreciation in the yuan. It is like an investment. With the Chinese central bank engineering a decline in the currency. Those who purchase Chinese assets would be losing money.

This engineered decline is part of the reduction in credit growth. When the currency continuously decreases, foreigners will not want to purchase Chinese assets. This will cause a decrease in investments. When this happens, the country will experience a credit crunch. This could potentially start a credit crunch.

I am not in favor of the Chinese central bank engineering this currency decline. Yes, it will cause increased interest in investment in the country. However, continued decline in the currency will decrease the returns on purchasing Chinese assets. This loss of interest will decrease the value of the yuan further. It could get to the point where the currency becomes nearly worthless. Chinese assets could lose their worthless. This could add to China’s economic woes, and the country could potentially sink into a depression and a financial crisis. The government would have to stop engineering this depreciation of the currency after a certain point, so investors will not pull out due to the growth in their currency investments.

 

Red Flag For Bitcoin

Is this the end for Bitcoin? Have we finally seen a weakness in the new potential “monetary” system? Just today Mt. Gox, the biggest and best-known Bitcoin exchange, was expected to file for Chapter 11 bankruptcy. There have been reports of extreme theft concerns when dealing with the viability of the electronic currency.  Bitcoin prices have fallen below $500 a piece for the first time since November, when prices were as high as $1,200.

So much for all the hype Bitcoin has gone through. I personally thought Bitcoin would see solid growth over the next couple of months leading into the summer and possible reach $1,400. But another side of me also believed that Bitcoin would have its’ dark days. However, I did not (along with many others) expect this to happen so soon. It is estimated that Mt. Gox lost 744,000 Bitcoins, or about 6 percent of the pseudo currency that’s in circulation worldwide. With this whole concept of complete electronic currency, we were bound to run into some type of hackers that would eventually create this downfall.

“With Bitcoin/crypto just recently gaining acceptance in the public eye, the likely damage in public perception to this class of technology could put it back 5-10 years, and cause governments to react swiftly and harshly.” Two-Bit Idiot blog mentioned who also first broke the story.

The unfortunate truth is that this is a serious hinder in the entire Bitcoin concept. But what I am really curious about, is whether or not this is problem that will eventually bring back the commotion, or is it the end of Bitcoin? Many people of the older generations take Bitcoin as some silly currency. They do not understand the full value that it would have especially with our technology driven world. Because of their mindset and with what has happened with Bitcoin, over the next couple of days, weeks, and months, we should expect a tremendous amount of criticism trying to finally take down the whole idea. But why should we do that? Why can’t we learn through our mistakes through these early ages of electronic currency? I could almost guarantee there were flaws when the American dollar first took off. There were flaws, theft, and many other problems with our currency then, and there are still problems today! Although this day in age everyone expects everything to be perfect when it deals with our currency or a new potential one such as Bitcoin. But overall, there will be steps made to ensure Bitcoin does not have a total collapse.

“The wider Bitcoin industry is seeking to both distance itself from Mt. Gox and offer reassurance about the virtual currency’s future. The chief executives of six major Bitcoin exchanges and other businesses pledged in a joint statement to coordinate efforts to assure customers of the security of their funds,” The Wall Street Journal addressed.

Looking at it from a ‘big-picture’ perspective, I do not believe the end of Bitcoin is in sight. Although our world might always have its’ thieves, whether it’s with Bitcoin currency or with each country’s current currency, our world is also just at the beginning ages of our day in technology. Our generation has the intelligent minds to continue to strengthen the Bitcoin system. Although I do believe this is a tremendous fault in the system, Bitcoin will resurrect to gain strength again even in the next couple of months.

Japan Showing Bad Signs

Recently, Asian markets have improved, but people have been cautious about Japan. The reason for this is that Japan’s growth has been slowing down very quickly. The Wall Street Journal reports that its GDP grew about 1% in 2013. This was below the expected 2.8% growth. This can also be seen with the weakening of the Yen compared to the US Dollar. The New York Times explores other factors. One of these larger factors was the .5% increase in private consumption. The Times connects this to the proactive spending of an increase in sales tax, which is expected to be imposed in April. The Washington Post, also attributes the slowed growth with the tax hike.

On the bright side, Japan’s currency weakened. This sounds bad, but it implies that each Yen is now cheaper. This means that Japanese assets are also less expensive. People will be more interested in purchasing these assets. When the demand for these Japanese rises, their prices go up, along with the value of the currency. Once this happens, the people, who have assets that are mostly in Yen, will see increases in the value of their assets. From what we can see here, this period of growth can be cyclical. Time will tell and we cannot be certain how much foreigners will be interested in a depreciating Yen. If not, then output could continue to decrease in Japan.

The big picture here is that increased sales taxes seem to hurt growth. What a surprise? Not actually because this can be explained with simple economics models. Using a basic supply and demand graph, we shift the supply curve in when there is a tax increase. The easiest effects to see are that the price level increases and the quantity consumed decreases. The quantity consumed can directly affect output since consumption is a component of GDP. The less obvious effects from the model are the decrease in both consumer and producer surplus. Decreases in surplus are other contributing factors to negative growth. Less surplus for consumers means that they will not have as much disposable income to spend on goods and services. This can hurt output even further. On the producer side, they will profit less with decreases in surplus. When firms see continuous decreases in their profits, they come closer and closer to going out of business. If firms continue to profit less, then the industries suffer, which also hurts output. We can see that increased sales taxes can create chain reactions that lead to decreases in output.

Inflation Scare in Argentina

This past week Argentina’s currency experienced its largest devaluation since 2002. This substantial devaluation has a caused a rise in inflation and uncertainty to grow within the economy. Argentina’s currency devaluation is not only a result of US tapering and weak numbers from China, but also long-term domestic policies that have created a large distrust in the Argentinian government.

According to the Wall Street journal many economists believe that the inflation is a result of “heavy state intervention, price controls and corporate nationalization that have underpinned their policy making for more than a decade.” (WSJ – Inflation Fuels Crisis in Two Latin Nations) To further the distrust in the central government, the state released inflation index for 2013 was reported at 10.9%, while an independent figure measured by an independent group of economists came in at 27%. (WSJ – Dispute Leads to Revise Index) As a result many local businesses are struggling to price their products and are being forced to close shop. One local coffin maker in Argentina said, “I have to tell customers that I can give you a coffin today, but you’ll have to pay for it later, at who-knows-what-price.” This confusion in pricing has resulted in decreased consumer spending and investments in Argentina. Bank of America Merrill Lynch recently forecasted that the decrease in investments and spending as a result of higher interest rates and inflation will lead to a 3% contraction in GDP this year. (WSJ – Inflation Fuels Crisis in Two Latin Nations)

Argentina has reacted to the inflation scare by issuing strict warning to business owners to not increase prices. The government warned that fines would be placed on businesses that continued to raise prices. If Argentina continues to mandate pricing, they may be able to temporarily curb inflation but businesses that rely on imports will be unable to sell products for profit. This will inevitably lead to further economic contractions.

As government discontent and uprising continues, one alternative plan for Argentinean citizens would be the adoption of Bitcoin or another cryptocurrency for payment. This would free businesses from the political constraints and corruptness of the central government and would provide them with better pricing transparency. Even though cryptocurrencies are known for being volatile, a large scale adoption from a country like Argentina could give the chosen cryptocurrency stability. Regardless, the high level of inflation currently present in Argentina is just as volatile, if not more volatile, as those of the cyrpotcurrencies. For small business owners that are at the mercy of pricing ceilings cryptocurrencies could be the only solution for these business owners. As inflation continues to rise and reach levels believed to be unstable by economists (about 50%), inflation will likely rise exponentially. When this occurs watch for Argentina to move towards cryptocurrencies.

Possible Beginning of the End of the Bitcoin Era?

Last week, Charles Shrem, a large Bitcoin tycoon, was put under house arrest. He was charged with money laundering among other various crimes. He is allegedly connected with a drug scheme that involved Bitcoin as the method of payment. This currency has been booming in recent times, but the decision of Shrem’s trial could have an impact on the future of Bitcoins. Shrem is the founder of a website that was widely used in the exchange of the online currency. According to the Wall Street Journal, Shrem is optimistic about Bitcoin’s future despite his arrest.

To add to the woes of the Bitcoin culture, Apple has been taking down all of the applications on its App Store that allow users to buy and sell Bitcoins. The most recent application to be taken down is called BlockChain. A New York Times Article mentions that the chief executive, Nicolas Cary, of the application describes Apple’s actions as “building a walled garden to interfere with innovation”. (Cary)

Interestingly enough, Bitcoins have inspired the concepts of electronic currencies. Professor Miles Kimball of the University of Michigan wrote his first article for Slate about ending the use of paper currency. He argues that Bitcoin is a great display of electronic money, but it is dubious that governments will give up their control over currency. By adopting an electronic currency, the government would be able to eliminate the zero lower-bound. Professor Kimball has been an advocate of this for a while now.

Bitcoins are a novelty within themselves. Online currency seems to be futuristic. Electronic transactions are easier and faster. The downside is that Bitcoins can be used for illegal transactions. This is because they are unregulated, therefore they are not being traced by a governing entity. It is not illegal to own Bitcoins because there are ways to purchase many legal items and services with them. The government cannot arrest someone for exchanging their dollars for Bitcoins. It would be impossible to prove that a person bought Bitcoins with the intent to be a part of an illegal transaction.

The United States adopting an electronic currency has its ups and downs. Transactions can be made more quickly. We see this with the use of credit and debit cards. A swipe and a signature are enough to make a payment. Another positive to electronic money is that the government can trace money even more than it can now. Money used for illegal transactions is almost always done in paper form because it cannot be tracked. Electronic money would allow the government to know what every dollar, every day, goes towards, thus curbing illegal activity. Professor Kimball is also an advocate of negative interest rates, which are only possible with electronic money. This is where I believe that the downside lies. With negative interest rates, people will be losing money every day unless they spend it. There would be no incentive to save. Furthermore, there would be no incentive to lend money. Creditors would cease to exist if they were to be paid back less money than they loaned.