The Mises-Hayek Business Cycle Theory and the Open Economies

0:00So the title of the paper I wanted to discuss is the ABCD Fiat Currencies and Open Economies. So when I send the title to the organizer, I forget to write fiat currencies. And that's actually I think the most important part of what I'm trying to say, what I'm trying to change. So basically to put it in a simple way, what I'm trying to do is take, Let me say like the Wagner's Challenge. So in his paper, discarding the chaff, keeping the wheat, he says, okay, IBCT usually assumes gold standard, commodity standard, monetary regime. Today we have fiat currencies, so what happens if we change this?

0:48Something happens, nothing happens. So that's what I'm trying to take on. So go from a canonical version with the gold standard or something like that, and move on to see what happens if we assume fiat currencies. There is no much written on these and in the context of open economies or international economies. Few papers and few chapters appears. Tyler Cowen, in his book, has a short chapter on the international effects of business cycles. There's a paper by Ritchie, and that's actually an extension of Garrison's model to international context. And a few recent paper by Hoffman and Schnabel, which are very interesting. So if you like this topic, I recommend you read those. So if we assume fiat currencies rather than a commodity-based monetary system, at least we have to question the first one.

1:42We don't have adverse clearing anymore. So if we have a gold standard and we start to issue bank notes, eventually we start to lose reserves, so eventually we have to stop with this monetary policy so the boom becomes a bust, and all the story we know. We don't have that anymore, at least in the traditional sense. So what is going to replace the adverse clearing? Or I can imagine someone asking if we don't have adverse clearing and what matter is the difference between inflation and expected inflation, why we can't inflate forever? We are not losing reserves. So I'm not saying we can't do that, but I think that someone may ask that question. So that's something that may be or may be required to be addressed. In this paper, I'm not dealing too much with this topic. I'm basically assuming that central banks don't want to have inflation. so inflation will be the trigger, not the lose of reserves.

2:29But still it's a question that may point to some interesting points. But if you have fiat currencies and central banks, then differently to a gold standard, a commodity standard, monetary regime, we have more than one currency and we have more than one central bank. So what happens when central banks start to interact with each other? That may do something. Also if we have more than one currency, we have a new price. we have a foreign exchange. If we have a new price, then we may have new distortions coming through the new price. So how this affects the business cycle theory. So this is what this paper is about. I give you the outline. The paper is divided in two big sections. The first one is the interaction between central banks in general.

3:18What one central bank decides to do affects the policy of the other central bank. The second section deals more with the effects that the big economy can have on small economies. I want to focus more on this topic today. And then there's a short bullet point at the end of the paper of where a business cycle with fiat currencies become more or less severe. And this has to do with some conclusions I found in Cohen and Ritchie. Because there is not much time, I'll give you the findings early. So the interaction between central banks, the points that can mislead monetary policy, we don't have adverse clearing anymore, we have a substitution, what central banks do, if the monetary policy gets misleaded, it can be extended in time enough to make business cycle more severe, I fail to react timely, and in this case of small open economies, we don't have only the traditional lengthening of the period of Production, or more on the aboundness.

4:20We also have effects on tradeable and non-tradeable industries, and by this I mean industries that produce goods that can be exported rather than just be consumed domestically, like housing. Yes? Okay, so this is the general setup. I don't want to use the word model here, but the idea is that we have a center and a periphery formed with small open economies, for example, the U.S. in Latin America, or Euro and some Eastern European countries, Japan and Southeast Asia. So this is the general framework that is going on in this article. So if we have fiat currencies, the first problem is, as I mentioned before, we don't have adverse clean, so what do we use as a substitute?

5:09We use inflation, we use unemployment, we use some kind of nominal spending measure, and productivity norm, what do we use? There is no clear agreement. It's not that we know which indicator we want to use and then we don't agree on what the monetary policy should be. There doesn't seem to be too much agreement of what we should be looking at in the first place. So that's already a problem that can set central banks off track. This of course in the context of this problem of monetary nationalism. and second, different central banks interact with each other and that has feedback effects. So let's say that we have the periphery and the center will take as given, like they make a mistake, they start to spend monetary policy too much and the periphery wants to keep foreign exchange rates stable, not to be facing appreciation because they don't want to hurt export industries or political reasons or for any reason they decide to keep foreign exchange rates.

6:11So they absorb the money of the center as reserves, if that currency is used as international currency of exchange. If the center starts to increase consumption, and that can be done with import of goods, then inflation can be postponed. So I think my monetary policy is going fine, but it's not. And if you have been following what has been discussed with the financial crisis in 2008, they should be sound very familiar, right? Imports Coming from Asia, China, and different countries. And we're not having high signs of inflation. Also, we don't see signs of depreciation or depreciation, so my foreign exchange rate seems to be fine. So this is a problem of looking at the wrong indicator.

6:57Therefore, I may be spending money for too long and business cycle can become more severe. Well, this shouldn't be too controversial. Eichengreen, Leiham-Futh, Taylor, William White, quite a lot of economists has point to this problem, so I don't think this should be very strange. Now, I want to move to the small open economies, because I think this can lead to something more interesting to do. So, we can have two scenarios, where the periphery decides to keep the foreign exchange stable, or what they decide to let the foreign exchange float. I will just focus on one of them, when the small open economies decide to keep the foreign exchange stable, just to illustrate the point, I will also make a simple scenario.

7:48So the center decides to increase money supply, imports increase, because I can buy goods from the rest of the world, the price of non-tradable goods increase before the prices of tradable goods, Housing will be an example. And resources in the center are relocated from tradable industries to non-tradable industries. Tradable goods, I can buy them from outside. Non-tradable goods, I have to produce them. The periphery, we have the mirror effect. Right, if the center starts to import more goods, then the periphery starts to export goods. The export dependency to the center increases. So you can have a relocation of capital goods from non-tradable to tradable industries. So this is a scenario I want to use as an example, which means we have two effects going on.

8:39On one side, the traditional lengthening of the period of production, we go to more roundabout industries. I'm not saying that's not happening, of course that's happening. But we also have a relocation between tradable and non-tradable industries. I want to make a small parenthesis, okay, so what? Right, we have the big set of capital goods, we make a distinction inside and we say, okay, we have also movements inside our big pot of capital goods, like, what's the big deal? Of course, you are, if you make some other distinction, we are also going to have some misallocations there. Okay, fine, the general story doesn't change, but if we distinguish between tradeable and non-tradeable goods, then we can apply this and we can make a comparison to other business cycles series applies to small open economies.

9:31And that's where I want to go. So let's see if we can picture this in Hayekian triangles. These effects. If there's an audience that can like Hayekian triangles and understand them, it's probably this one. So this is a Hayekian triangle, enlarged, right? So this is the consumption axis, stages of production, this blue area, that will be the traditional triangle we see when we read papers using this diagram. So this panel is what we usually see. That's the same thing. Now we are at this line. This line has the share of capital goods assigned to tradable and non-tradable industries.

10:19So we can say this dark gray area, that's capital goods assigned to tradable industries, and the light gray area, that's capital goods assigned to non-tradable industries. So that's a standard triangle, blue triangle, normal situation, nothing happens. Then come our friends from the central banks, and they decide to expand monetary policy, and that happens. So we have to make sense of that. So let's go step by step. We have our blue usual triangle. The red lines is the effects of monetary policy, so we have the traditional triangle being pulled on the both sides.

11:04That's still going on. This red area, that's the extension of the period of production across the board for our industries or the whole economy. And this green area, that's a relocation of capital goods from non-tradable industries to tradable industries, going, if you want, on another dimension or from another point of view. This area, that is not marked, that will be that capital goods are not only shipped from non-tradable to tradable, but also to lengths, both effects happening together. So when the boom becomes a bust, we have these two areas that have to correct together, not only one. Now, this is a graph of the small open economy, what happens in the small economy when the big economy does something.

11:54So we should have the same triangle for the center and another triangle for the periphery for fixed exchange rate and then two other graphs for floating exchange rate. I'm not going to show you that, you can read the paper, but I think you get the idea. So why this is important, or why I think this is important. So what happens with conventional theory? Like we have a small open economy, there's a monetary shock, and conventional wisdom says that depending on the kind of shock we have, we should follow a floating exchange rate or a fixed exchange rate. If we are in front of a monetary shock, then we want to fix exchange rate, so the monetary shock does not transmit real effects to the economy.

12:41If we have a real shock, then we want a floating exchange rate. Floating exchange rate prices are just fast, so that can help to adjust relative prices faster. Now when we go and take the empirical data, we put them in our regression, the HG models, and all the stuff that we ensure so much to do. We sometimes find these effects and sometimes we don't, which means if you have a monetary shock and you have two economies, one with floating exchange rates, another with fixed exchange rate, you should see business cycles behave differently because they are following different exchange rates in face of a monetary shock. Sometimes you find that, sometimes you don't. And that's a problem that Canova finds. Canova starts to study Latin America and he says that all countries, independent of what foreign exchange they have, they become more or less the same and his puzzle, he doesn't get an answer of why that happens.

13:41Well, that happens because of this. This is happening whether you follow one foreign exchange rate or not and if this effect is strong enough, it can drive your aggregate in the same behavior. It's not that this is not happening or the other parts of the theory are not occurring but you are missing a piece. So this kind of, if you want conventional approach or Mandel-Fleming approach, et cetera, I'm being silent whether that's right or wrong. I'm saying it's incomplete. And that incompleteness is not trivial because what was a puzzle starts to make sense. So let me show you one more slide. This is very, very preliminary. This is something I shall start to look very recently so I don't want to be too focused on particular numbers but how this will look like.

14:32So I go to Latin America and I choose two countries, Colombia and Panama, one with floating exchange rate. Colombia, Panama is solarized, so that will be a fixed exchange, the fixed exchange economy. And I want to look what happens between 2002 and 2007, between the dot com and the 2008 financial crisis. Right, if the center is following and a Sustainable Monetary Policy, when the shock comes, that shock is not in itself the cause of the crisis, that's one of the effects. So I want to know what happened before the shock, to make sense of what happens after the shock. So I divide following some kind of common sense, the industries in Colombia and Panama between more roundabouts or more capital intensive, maybe that will be more precise, and less roundabout for each one of those countries.

15:24So, how did they behave? Well, this number had actually grown, that 31 should be almost 50, and this eight, I did my math wrong, sometimes happens, right? But the idea is that both economies, with different exchange rate, they are having their more capital intensive or their more roundabouts or however we want to call them, growing much more faster than the less roundabout in both cases. And Canova and that kind of work cannot make sense of why business cycles behave the same when you follow different foreign exchange rate because they are not looking at this. They're missing capital theory, right? What Nikolai Foss was talking yesterday. That's a fundamental piece. So this is where I think this kind of approach, take the ABCT, update it to fiat currencies and then you can maybe say something to business cycle theories applied in small economies.

16:20Okay, so thank you for your time. Thank you very much.