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Discussion of Prudential Policy for Peggers by Schmitt- Grohé and Uribe

Discussion of Prudential Policy for Peggers by Schmitt- Grohé and Uribe. Andrew K. Rose UC Berkeley, NBER and CEPR. What’s the Paper About?.

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Discussion of Prudential Policy for Peggers by Schmitt- Grohé and Uribe

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  1. Discussion ofPrudential Policy for Peggersby Schmitt-Grohé and Uribe Andrew K. Rose UC Berkeley, NBER and CEPR

  2. 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”

  3. Key Findings • 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. • Optimal capital controls set by gov’t raise welfare a lot (permanent 7% of consumption) • Optimal capita controls are “prudential” in that inflows taxed in good times; external borrowing subsidized in bad times.

  4. 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

  5. Prudential? Definition: • “of, relating to, or proceeding from prudence” Definition of prudence: • the ability to govern and discipline oneself by the use of reason • sagacity or shrewdness in the management of affairs • skill and good judgment in the use of resources • caution or circumspection as to danger or risk

  6. 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

  7. 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

  8. 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)

  9. 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

  10. Two Critical Assumptions • Wages are downwardly rigid • 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

  11. 1: How Rigid are Wages? McLaughlin “Rigid Wages” JME 1994 0

  12. Heckel et al (ECB, 2008) 0

  13. 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)

  14. Most Fixed Rates aren’t (Fixed)

  15. The Global Economy isn’t (Fixed)

  16. 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.”

  17. My Bottom Line • Take a standard model, add two ad hoc assumptions, stir in unorthodox policy • Limited generality • Can sub-optimal monetary regime be perfectly credible? • Reasonable to assume wages rigid forever? • Sustainable/optimal to use capital controls to solve labor market distortion? • Implausible welfare benefits from capital controls • Judgment: Curate’s Egg (good in parts)

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