Exchange Rates and Modern Trade Theory: An Interview with John Harvey

John Harvey is Professor of Economics at Texas Christian University. He blogs at Forbes and is the author of the book ‘Currencies, Capital Flows and Crises: A Post-Keynesian Analysis of Exchange Rate Determination’

Interview conducted by Philip Pilkington

Philip Pilkington: Your book seeks to outline an alternative theory of what determines exchange rates in our world today. Your approach is quite self-consciously grounded in realism – something which, if I understand correctly, you felt you did not find in the mainstream neoclassical theories. Perhaps before we go into your ideas we might first discuss the mainstream theory a little. While there are different approaches within the mainstream it seems to me that they all assume two features. That is, they assume that trade balances between countries reach equilibrium in the long-run (i.e. there will be no trade surpluses/deficits in the long-run) and they also assume that capital flows are neutral. Could you please talk about the mainstream approach in terms of these features and explain the implications and problems that arise there from?

John Harvey : You are dead on in terms of the distinction between my work (and Post Keynesianism in general) and that of Neoclassicals. Indeed, the mainstream views capital flows as neutral which then means that the only real determinant of the demand for foreign exchange is trade. Therefore, a trade surplus nation must necessarily find itself in a position where there is an excess demand for its currency since there is an excess demand for its goods and services. And, voila, this will cause its currency to appreciate and the trade surplus to disappear. Trade deficit nations face an analogous situation. So, take heart, nations whose firms are outcompeted by foreigners and who find themselves losing jobs and income to imports, for the free market will automatically correct this for you AND leave the world with a more efficient allocation of resources. So say we all (a joke for all you Battlestar Gallactica fans)!!!

But this does not explain why Neoclassicals take this approach, and that answer is a function of when their school of thought evolved. In the 18th century, popular currents in intellectual theory were Newtonian physics, political individualism, and Cartesian deductivism. With respect to the first, Isaac Newton had argued that the physical world was governed by a system of natural laws that tended to create self-correcting equilibria. A body at rest stays at rest and a body in motion stays in motion, for example. Adam Smith was a great admirer of Newton and incorporated these concepts. He and particularly his followers thus posited an economy driven by natural laws and tending towards resting points: things like balanced trade.

Political individualism was part of the democratic revolution and was based on the idea that individuals had natural rights (which was indirectly related to Newton’s natural laws). Those who govern do so with the consent of the people, not because they were chosen by God to do so. One of the manifestations of this in the economic realm was the belief that people had a right to choose their profession, what they consumed, etc. And, since they were trying to convince others of the superiority of this free-market view, it was commonplace for early economists to also argue that such an arrangement automatically created superior outcomes. Combined with Newtonian physics, this created the tendency for our models to not only assume that economies were self-correcting and led to equilibrium positions, but that these equilibria were socially superior to what was possible with even well-intentioned government intervention. This is consistent with Neoclassical exchange rate theory which says that in the long run, trade is both balanced and yields optimal and efficient employment of resources.

Post Keynesian economics is different not just because it isn’t so closely tied to Newton or a perceived need to build a case for capitalism, but because they reject the third influence mentioned above: Cartesian deductivism. Descartes argued that we cannot rely on our senses in trying to understand the world because they are contaminated by our experiences, preconceptions, etc. We will tend to see what we expect to see or what others, who may be in a position to create false information, want us to see. Only our reason is a reliable guide to how the world works. I explain this in class as being like the situation in which Neo finds himself in the movie The Matrix. Not to ruin the movie for readers who have not seen it, but he senses that what he saw around him was not real. His instinct told him that the true reality was significantly different, something that was confirmed once Morpheus gave him the red pill. Neo’s reason was correct, while his senses were wrong.

What this means for economics is that in building the premises of our models, the right approach is not to dig through historical and institutional data but to coolly and rationally consider what seems to make the most sense. This, adherents argue, is the only reliable method. Detractors like the Post Keynesians, however, say that instead that it effectively allows Neoclassicals to make assumptions that may not only appear to be very rough approximations, but are downright false. Furthermore, these are every bit as much affected by preconceptions and now lack any means of anchoring them to what we see around us. To put it very bluntly, you can make up whatever crap you want in order to ensure that you come to your preferred conclusion! Their constant invocation of the long-run compounds this because it permits them to constantly interject, “No, your prediction hasn’t come true yet, but it will eventually!”

As you suggest in your question, Post Keynesians prefer realism. In short, we not only see it as an absolute necessity to link our premises and model predictions to observations of the real world, but a key part of doing this properly is tracing the line of causation in any process. It is not good enough (as it is in Neoclassicism) to say that A is somehow correlated with E. Instead, good Post Keynesian research says A leads to B which leads to C which leads to D which leads to E. Furthermore, each connection must necessarily be justified in terms of the structure of real-world institutions. I doubt very seriously if an article employing the monetary-policy helicopter from Milton Friedman’s classic article would even make it past the editor at the Journal of Post Keynesian Economics, Paul Davidson. I certainly hope not!

And so my theory of exchange rate determination takes this approach. It does not assume that free-market solutions are best, but nor does it view them as useless. In addition, I endeavour to build explanations of causal processes grounded in historical and institutional data. And, while I do use equilibrium in some parts of the model, this is an expedient. The capitalist system is dynamic and more akin to a biological phenomenon, changing and evolving over time, than a physical one.

PP: One key aspect of your approach is that you take human psychology to be a key driver of the currency markets. It seems to me that the main reason you lay so much emphasis on this is that, in contrast to neoclassical economics, you believe that expectations are not necessarily rational and that they may have strong effect on currency price movements. Perhaps you could talk a little about this and just how important it is in the determination of exchange rates?

JH: The line of reasoning that leads to the importance of human psychology starts with the idea that currency markets are dominated by portfolio capital flows. In Neoclassicism, trade flows are dominant and finance simply passively accommodates the needs of the real side of the economy. But, from the Post Keynesian perspective, money is important and a core driver. The main reason currency prices move is that international investors are adjusting their portfolio of assets. Trade flows are then forced to adjust.

So, if currency prices are driven by capital flows, the next logical question is what drives capital flows. And that is where human psychology steps in. Capital flows focus on the expected appreciation of assets – expected! Now, if agents coolly and rationally forecast future price movements in a manner that mirrored fundamental factors, then the psychology would not be terribly important. But, as you have noted, no such assumption is being made. Agents do their best in an uncertain world, being rational when possible. But as Keynes wrote in chapter 12 of the General Theory:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

And this is why I focus on psychology. We most certainly cannot ignore conventional factors such as trade flows, GDP growth, interest rates, etc., as agents use those as inputs in their decision making process. But the manner in which they interpret them is tied up with psychology.

PP: This may seem like a sort of strange question but, especially given that we’re on the internet, I’d really like to get your take on it. Especially since online or retail trading platforms have been launched it appears to me that there are more and more people in the FOREX markets with… well… let’s say they possess some rather unusual ideas about how economies function. I’m thinking of the sort of people you find on websites like Zerohedge or those listening to Austrian pundits like Peter Schiff who seem to be convinced of looming hyperinflation and all sorts of weird stuff.

Now, it strikes me that it is these people who are possibly the best “pure” case to focus on from the standpoint of what perhaps we could term “irrational expectations”. And given how numerous they are – not to mention the role they may play in the gold and silver markets – I’d be very interested in your take on them. Perhaps if you’re familiar with these people you could use them as a starting point from which you might elaborate on the role of straight-forward irrationalism, herd behaviour and even superstition in the contemporary capital driven currency markets.

JH: You are quite right that the influence of these individuals have increased and that this might inject even more irrationalism, etc. That said, a) I’m not sure that their sheer numbers are yet sufficient to warrant an explanation of exchange rate determination that focuses on their behavior and b) we don’t need to include them to see plenty of irrationalism, herd behavior, etc. The professionals themselves are sufficient!

Take Thomas Oberlechner’s work. He is a psychology PhD who finds exchange markets fascinating and his research has been enlightening. For example, he found that currency dealers’ #1 source of information for indications of future exchange rate movements is the financial press. Guess who the latter’s #1 source is?! Currency dealers. Hence, what he says can happen with some regularity is that a reporter will call a dealer and ask, for example, “Where do you think the euro is headed?” The dealer is naturally flattered and spends the next ten minutes laying out various potentially very speculative scenarios. Even if they are careful to moderate their claims, these end up in print and thereby take on an air of authority. Rumor becomes fact, AND THIS DRIVES THE MARKET!

Another of his findings that really stands out in my mind is that when he asked dealers what was the most important quality of information they received, they said that it was getting it first. Whether or not it was accurate was down the list! Why? Because accurate or not, it will move the market, and if you get it first then you make a profit. Again, this is all among the professionals. We can then take this a step further and recall Keynes’ admonition that even those who realize what is really going on are better off playing this game with everyone else. Smart money loses if the market is being driven by stupid money.

PP: Fascinating. But if all the psychological evidence shows that moves in these markets are made based on self-fulfilling expectations then how do the neoclassicals continue to argue that markets are rational? My understand is that they make this assertion based on the idea that those in the markets that are persistently “irrational” will be weeded out by others who make profits being “rational”. But what you just alluded to seems to indicate that it is often more rational to be irrational – if that makes any sense…

JH: I think that’s basically right. A couple of thoughts on that: First off, the Neoclassicals have maintained their rationality argument by using the very same escape about which Keynes complained: the long run. You will find that in their literature, they will admit “some irrationality” in the short run, but their faith in the invisible hand leads to the conclusion that in the long run it all works out. I even once read an author who said that studying short run exchange rate movements weren’t economics at all! It’s a classic case of redefining the subject matter rather than altering the theory or tools of analysis.

Second, all this begs the question of what “rational” means. Neoclassicals define it so narrowly that it is not entirely obvious that just because what we see in the real world may not fit their definition, it is not nevertheless sensible given the structure of the institution of foreign exchange trading. Does it generate optimal economic outcomes? No. Are those participating in the current market acting sensibly given the existing incentive/reward structure? That seems likely.

Third, while these markets are, strictly speaking, driven by self-fulfilling prophecy, that does not mean that those involved are not following an economic logic of sorts. I argue this somewhere in the book (where escapes me at the moment!). Currency dealers, etc., are members of a social subgroup whose worldview is based on an understanding of exchange rates premised on the importance of GDP growth, unemployment, interest rates, inflation, etc. In other words, they aren’t basing their forecasts on how short Bernanke trimmed his beard this week! However, the link between the fundamental factors is tenuous. Thus, as Keynes says in chapter 12 of the General Theory:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

PP: There’s been quite a bit of discussion on the blogs about the status of Thirlwell’s Law – that is, that an economy’s growth is constrained by the growth in their exports. Some claim that this is indeed an absolute law. Others, however, say that it depends on institutional issues – such as the status of a given currency in the world markets. From your research what have you concluded?

JH: I have concluded that I’m intrigued but still on the fence! I did an edited volume with Johan Deprez (one of Paul Davidson’s students) many years ago, and Thirlwall contributed. His chapter has proved to be one of our most cited. I never could, however, get away from the idea that the real key was the fact that domestic demand could be saturated (particularly investment), leading to recession and unemployment. That said, I recall Paul Davidson being a real fan. As for me, however, I just don’t know what to think about it!

PP: Well, what about a more concrete example then. Some commentators have been quite surprised that the US has been able to sustain a current account deficit for so long without seeing significant downward pressure on the dollar. What do you make of this? Do you believe that it is sustainable?

JH: That’s an excellent question and relates to a common misunderstanding (in both the popular press and the economics profession). If one assumes that the only or primary reason to buy FX is to finance trade then, yes, every time a country has a trade deficit this means that there is an excess supply of their currency and it will depreciate (and when there is a surplus, there is an excess demand that leads to appreciation). But, that ignores the possibility of large and independent capital flows. So long as US financial assets are popular with the Chinese, the US capital account surplus offsets the US trade deficit and we are in equilibrium. How long can this last? Assuming that US financial assets are popular with the Chinese, indefinitely.

Furthermore, it can be the capital account imbalance that causes the trade imbalance. For example, during the run up of the dollar through February 1985, US financial assets were extremely popular (due to the recovering US economy and our high interest rates). This, of course, made it more difficult for American firms to export and contributed to the widening US trade deficit. All this said, trade tends to be relatively price insensitive, but it still plays a factor. The bottom line here is that one simply cannot focus on trade flows when considering the currency market. In fact, you are better off focusing on capital markets.

PP: To wrap this up maybe you could talk a little about the effects financialisation has had on currency movements. From what you just said about the US it appears that a good deal of the reason for the sustained trade deficits in the US can be traced back to capital assets being issued by Wall Street. Perhaps you could reflect a little on this? Is it sustainable?

JH: This is definitely key. Financialization has meant that currency prices have increasingly become reflections of the volatile and subjective expectations in the financial market rather than prices that serve a useful purpose in the allocation of international resources. Ironically, as they have become more skewed in terms of being relevant economic indicators, so professionals and lay people have treated them as more important. This of course mimics what we have seen happen with domestic financial markets. And the fact that international financial flows are roughly ten times the size of trade flows means that the latter tend to respond to exchange rate movements rather than cause them. And yet, every major neoclassical currency model assumes the latter to be true at least in the long run!

With respect to sustainability, making such an evaluation is fraught with problems. Taking the US and China, the question is how long the latter will accept financial claims in exchange for goods and services. In our gut, we all assume there has to be a limit – but where? Part of the problem is that as the levels of debt rise, so we adjust (as Minsky said) our sense of how much is too much. In addition, when China stops extending credit, they stop exporting! So while I think such discussions are useful and interesting, I wouldn’t dare make a forecast beyond: “The deficit can exist so long as China is willing to buy US financial assets!”