Discussion of
Prudential Policy for Peggers
by Schmitt-Grohé and Uribe
Andrew K. Rose
UC Berkeley, NBER and CEPR
What’s the Paper About?
• “the benevolent government has an incentive
to vary the effective interest rate (through
capital controls) as a way to insulate the
nontraded sector from external shocks”
• “the government levies taxes on external debt
as a way to mitigate the distortion in the labor
market created by the combination of
downward wage rigidity and a fixed exchange
rate”
2
Key Findings
1. Negative pecuniary externality: good shocks
raise nominal wages, which don’t fall in bad
times. Gov’t internalizes this; CB can’t help
because of fix.
2. Optimal capital controls set by gov’t raise
welfare a lot (permanent 7% of consumption)
3. Optimal capita controls are “prudential” in that
inflows taxed in good times; external borrowing
subsidized in bad times.
3
Plausible Exercise?
• Seems reasonable to doubt a theoretical
exercise that adds assumptions and
“prudential” capital controls to a DSGE
model, and finds such massive welfare
benefits and reduction of average
unemployment by 10 percentage points
4
Prudential?
Definition:
• “of, relating to, or proceeding from prudence”
Definition of prudence:
1. the ability to govern and discipline oneself by
the use of reason
2. sagacity or shrewdness in the management of
affairs
3. skill and good judgment in the use of resources
4. caution or circumspection as to danger or risk
5
Clearly Third Definition
• Here the government benevolently exercises
“skill and good judgment in the use of
resources” (capital controls)
• Note: government subsidizes capital flows
during bad times (an action defined here as
“prudential”)
– Makes this MIT graduate nervous, though clearly
OK for Chicago graduates
6
What’s the Objective: Europe?
• Single European Act (Single Market): free flow
of goods, services, labor and capital by
12/1992 (“Four Freedoms”)
– Typically viewed as more critical than EMU
• Paper concerns a Credible Peg, not Currency
Union
• Calibrated to Argentine data
7
What’s the Objective: Capital
Controls?
• Here Government taxes/subsidizes net external debt
• But … no consideration of microeconomic costs
(corruption, costly evasion, …)
• Controls here: big and volatile (seems problematic)
• Distortion is in labor market: Why not intervene
more directly in labor market?
• Typically want to intervene close to locus of distortion
(Bhagwati)
• Capital controls don’t seem second best (third at most)
8
Typical Arguments for Controls
• Tax inflows to reduce potential for “hot
money” capital outflows, default risk
• Tax inflows to reduce exchange rate
appreciation
• Tax inflows to reduce inflationary pressures
• All irrelevant here
9
Two Critical Assumptions
1. Wages are downwardly rigid
2. Exchange Rate Pegs are Perfectly Credible
• Both key, both questionable (esp. second)
– In a different era, both might be seen as ad hoc
• Together, strong flavor of 1960s-era Mundell
10
1: How Rigid are Wages?
McLaughlin
“Rigid Wages”
JME 1994
0
11
Heckel et al (ECB, 2008)
0
12
2: How Credible are Pegs?
• Paper ironically calibrated to Argentine data
1983Q1-2001Q4
– During this time, four currencies (Peso ley, Peso
argentino, Austral, Peso convertible)
– Big collapse at sample end
– Big balance sheet effects (liability dollarization),
but irrelevant in theory here (if not in practice)
13
Most Fixed Rates aren’t (Fixed)
Exchange Rate Regime Switches over Time
Proportion of Global GDP in Economies with Changing Regimes
.4
.2
0
0
.2
.4
.6
Levy-Yeyati & Sturzenegger
.6
IMF De Jure
1970
1980
1990
2000
2010
1970
1990
2000
2010
.4
.2
0
0
.2
.4
.6
Reinhart & Rogoff
.6
Shambaugh
1980
1970
1980
1990
2000
2010
1970
1980
1990
2000
2010
14
The Global Economy isn’t (Fixed)
Exchange Rate Regimes over Time
Distribution of GDP by Currency Regime
Levy-Yeyati & Sturzenegger
100%
100%
IMF De Jure
50%
Float
50%
Float
Intermediate
Intermediate
Fix
1970
1980
1990
0
0
Fix
2000
1970
1980
1990
2000
2010
Reinhart & Rogoff
100%
100%
Shambaugh
2010
Float
50%
50%
Non-Peg
1970
1980
1990
Fix
0
0
Peg
Intermediate
2000
2010
1970
1980
1990
2000
2010
15
Obstfeld-Rogoff on
“Mirage of Fixed Exchange Rates”
“The striking conclusion is that, aside from some
small tourism economies, oil sheikdoms, and
highly dependent principalities, there is
literally only a handful of countries in the
world today that have continuously
maintained tightly fixed exchange rates
against any currency for five years of more.”
16
My Bottom Line
• Take a standard model, add two ad hoc
assumptions, stir in unorthodox policy
• Limited generality
1. Can sub-optimal monetary regime be perfectly
credible?
2. Reasonable to assume wages rigid forever?
3. Sustainable/optimal to use capital controls to solve
labor market distortion?
4. Implausible welfare benefits from capital controls
• Judgment: Curate’s Egg (good in parts)
17