Discussion ofPrudential Policy for Peggersby Schmitt-Grohé and Uribe

Andrew K. RoseUC 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”

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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.

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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

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Prudential?

Definition:• “of, relating to, or proceeding from prudence”

Definition of prudence:1. the ability to govern and discipline oneself by the

use of reason2. sagacity or shrewdness in the management of

affairs3. skill and good judgment in the use of resources4. caution or circumspection as to danger or risk

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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

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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

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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)

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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

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Two Critical Assumptions

1. Wages are downwardly rigid2. 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

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1: How Rigid are Wages?

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McLaughlin “Rigid Wages”JME 1994

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Heckel et al (ECB, 2008)

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0

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)

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Most Fixed Rates aren’t (Fixed)0

.2.4

.6

1970 1980 1990 2000 2010

IMF De Jure

0.2

.4.6

1970 1980 1990 2000 2010

Levy-Yeyati & Sturzenegger

0.2

.4.6

1970 1980 1990 2000 2010

Shambaugh

0.2

.4.6

1970 1980 1990 2000 2010

Reinhart & Rogoff

Proportion of Global GDP in Economies with Changing RegimesExchange Rate Regime Switches over Time

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The Global Economy isn’t (Fixed)

Fix

Intermediate

Float

050

%10

0%

1970 1980 1990 2000 2010

IMF De Jure

Fix

Intermediate

Float

050

%10

0%

1970 1980 1990 2000 2010

Levy-Yeyati & Sturzenegger

Peg

Non-Peg

050

%10

0%

1970 1980 1990 2000 2010

Shambaugh

Fix

Intermediate

Float0

50%

100

%

1970 1980 1990 2000 2010

Reinhart & Rogoff

Distribution of GDP by Currency RegimeExchange Rate Regimes over Time

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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.”

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My Bottom Line

• Take a standard model, add two ad hoc assumptions, stir in unorthodox policy

• Limited generality1. 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)

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