HowTo: Dirty floats
I figured I’d write this one, since I talk about it so often, albeit in passing. A ‘dirty’ float is a managed float. Why it’s called dirty I don’t know, but I’ll bet some free-market monetarists were behind it.
In principle, most developed OECD countries have floating exchange rates – the value of your currency fluctuates freely, and according to various factors such as interest rates, economic activity, export activity, etc. In the case of the US dollar we can add to that the demand for greenbacks as operating cash by small governments, NGOs, multinationals, etc.
Typically, we allow our currencies to float freely between certain bounds – our dollar can swim, but only between the flags (that might only work with Australians, actually). China, for example, had a – very unpopular – fixed exchange rate up until fairly recently. Even now, the degree to which is manages its currency is still unpopular.
The key to managed floats is that, with a floating dollar, one’s domestic economy is exposed. In Australia, for example, our currency:
Did fairly well, up until around a month ago when speculation died down and/or the speculators took their profits. I used a longer time trend in my previous post – it was much more impressive. The pressure has died off a bit, now that we have had the interest rate increase.
Now then, what happens if the Australian dollar gets too high? Australian exporters take a big hit, because our prices become too expensive on the world market. Our macroeconomy slows down some as those declining export incomes kick in. Meanwhile, if speculation is the cause of the appreciating currency, there can be a liquidity problem, because foreign companies are borrowing up all of our money, rather than domestic firms and households. If they drive interest rates up, that too slows down our macroeconomy via consumption and investment. Our Current Account Deficit also deteriorates.
If, on the other hand, the Australian dollar were to depreciate too far (as per the Asian currency crisis), we have trouble attracting foreign capital because the return on those loans are too low. Our Current Account Deficit benefits but our debt becomes much worse (if it is in, say, US dollars, which is often the case). In this case the Reserve Bank enters the ForEx market and buys up Australian dollars, so that its value appreciates.
The key to a managed float is market invervention (as opposed to interference) designed to prevent external pressure getting through to a domestic economy. As a rule, this ‘getting through’ is considered bad when the domestic economy would be thrown out of whack. In the case of China, for example, their economy was already out of whack – prospering from a low Renminbi, which is being kept low to keep exports selling. Managed floats that are designed to sustain non-equilibrium conditions for a domestic economy relative to the rest of the world are the ‘dirty’ kind. Given the level of international trade these days, almost all domestic economies are exposed to currency fluctuations (the other big factor in the AUD appreciating has been the commodities boom, driving up legitimate demand for our currency, in order to buy our commodities). As a result most floats are managed.
This, finally, is where my comments about US borrowing come in. With a level of debt equal to USD29,551.77 per citizen, and a Congress continually raising the debt cap (feeling fat? Let your belt out!), more and more money needs to come into the country as lending. For the US a depreciating dollar helps their debt, kind of, but they have to pay it off with predominantly US dollars anyway, so. Along the way, a depreciating dollar makes getting loans more difficult (except from China, who can extend lines of credit to the US all day long, if they’re buying their plastic crap. Same with Saudi Arabia and their oil), necessitating interest rate increases to attract capital. However, at the moment, those interest rates are under a hell of a lot of fire from financial and housing markets.
It can become a mess very rapidly. In a managed float, the Federal Reserve’s incentive is to go and buy up US dollars to shore up their value. The trouble with that is the downward pressure is fairly strong these days, and a central bank cannot manage a float forever (usually – even China’s will be unsustainable, eventually). If China really does go through with diversifying it’s portfolio, that pressure will certainly increase.
Basically there’s only so much tide a central bank can hold back. Immediate crises? Fixable. Long-term pressure? Not so fixable, but softenable, at least. Hence my comment on the previous post, that we’re seeing aggressive central bank activity, but not float-managing. Principally, this is because currencies are not the vector for this contagion – international trading of frankendebt CDOs among companies is. If it carries across to currency, these banks will need some more fancy moves, but for now they just have the much more difficult task of trying to manage liquidity drying up because everyone’s selling debt that nobody wants.