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Simon Wren-Lewis: Is a currency crisis bad for you at the ZLB?: Noted

Simon Wren-Lewis: Is a currency crisis bad for you at the ZLB?:

The discussion centred on the UK, but it is more general than that: a similar thought experiment is if China sells its US government debt.... The track I want to pursue starts from my argument that Quantitative Easing (QE) will ensure that the UK government never runs out of money with which to pay the bills. The obvious response... is that a market reaction against UK government debt might be accompanied by a reaction against the UK’s currency, leading to a ‘sterling crisis’.... Suppose Labour had not lost the election, and austerity had been delayed (by more than Ken Rogoff would have thought wise, bearing in mind that he agrees that government ‘investment’ in its widest sense was in fact cut too aggressively)... markets had decided that... it was no longer wise to buy UK debt. QE fills the gap, but the flight from UK debt is also a flight from sterling, which depreciates....

There are two directions we could follow at this point. One would be the idea that a depreciation makes the UK government insolvent.... But it's not clear how this would work when exchange rates are flexible. The depreciation would do nothing to raise current or future borrowing costs, or reduce the long term tax base. At some stage markets would realise their mistake....

The second direction is to focus on the short run costs of the nominal depreciation.... As domestic prices are sticky, the depreciation increases UK competitiveness, which increases the demand for UK goods. If the Zero Lower Bound (ZLB) is a constraint, then this increase in demand reduces or eliminates the constraint. It may also raise inflation because demand is higher, but higher demand is what monetary policy wanted but was unable to achieve.... The ZLB is a welfare reducing constraint that the crisis relieves, and we are all better off.... [That] treats the depreciation as simply a positive demand shock....

However a sterling crisis may also involve a deterioration in the output/inflation trade-off.... The central bank will have to raise interest rates to prevent these expectations fully feeding through into actual inflation. Either output will be lower, or inflation higher, or both. Now as long as interest rates stay at zero, this is not a problem: the ZLB constraint still dominates. However if the crisis was big enough, we could overshoot... and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much....

But what about 1976, when pressure on sterling led the UK government to seek help from the IMF?... There seemed to be a mindset among senior policy makers that sterling was on a kind of slippery slope. Once it started falling, who knows where it might end up? They seemed to believe there was a bottomless pit, and the IMF loan was required to stop us going there. I suspect that was in part just a lack of familiarity with how flexible exchange rates work. In the end, sterling did stabilise such that some of the IMF loan was not needed, and I wonder how necessary it really was. But if anyone who reads this post knows more about this period, I would be very interested in their thoughts.

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