Forex Markets show how Krugman’s Textbook Theory is Wrong


by Emmanuele Canegrati*

International economics textbooks have always taught students that currency exchange rates in forex markets depend, among many other things, on the monetary policy stance chosen by global central banks.

Krugmans textbook theory is wrong
Krugman’s textbook theory is wrong

A famous rule of the thumb written by Keynesian Nobel laureate Paul Krugman in his ‘International Economics’, considered a true bible in the macroeconomic theory, explains that expansionary monetary policies, consisting of cutting interest rates or increasing the money supply (or a mix of the two measures), produce a devaluation of the domestic currency, since the advantage of holding it decreases compared to the yield offered by financial assets denominated in other currencies.

Conversely, restrictive monetary policies make domestic currency-denominated assets more attractive to investors and this entails an appreciation of the domestic currency against the other currencies. 
In the financial and economic crisis we are experiencing, the Federal Reserve and the European Central Bank, the two most powerful central banks in the world, have undertaken exceptional, unprecedented monetary policies, bringing interest rates to zero (in the US) or below zero (in the Eurozone) levels and initiating direct (in the US) or indirect (in the Eurozone) debt monetization policies on an unprecedented scale. Money printing has reached a trillion-dollar size. 

From the injection of fresh money of such an amount we would have expected, from a macroeconomic theory perspective, a euro-dollar exchange rate of a volatility never seen before. Instead, the euro-dollar exchange rate remained surprisingly unchanged, fluctuating in the trading range 1.08 – 1.10 since the beginning of the crisis. This evidence represents a great challenge, or defeat, for the traditional international macroeconomic theory, whose assumptions seem to have failed, and deserves to be analyzed more in depth.

Let’s take a look at some data related to the dimension of the monetary policies undertaken by the Federal Reserve and the European Central Banks to tackle the crisis. According to the Federal Reserve Bank of Saint Luis, the effective federal funds rate, the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight, has decreased from 1.58% in February to an almost-nil 0.05% in April, the latest data available. Thus, the reduction of the fed funds has been equal to 1.53% and the rates hit an historical record low. Rumors also hinted that the FED could have gone even further, bringing interest rates into negative territory, before the governor Jerome Powell was forced to declare that that option was excluded, for not to introducing a tax on savings and on US citizens’ pension funds. On the contrary, the European Central Bank decided not to take any action on interest rates. The three ECB key rates, namely the rate on deposit facility, the rate on main refinancing operations and the rate on marginal lending facility, have remained unchanged to -0.5%, 0.0% and 0.2%, respectively. The last time the ECB cut a key rate was on 18 September Governing Council meeting, when the deposit facility was reduced to -0.5% from previous -0.4%. The choice to keep interest rates steady raised fierce critiques against the central bank and its new governor, Christine Lagarde, accused not to do ‘whatever it takes’ to help the battered Eurozone economy. The critiques did not have any effect and the interest rate policy did not change. 

As a consequence of the two central banks’ decisions, the rate differential between the US and the Eurozone has almost zeroed. In the meantime, the euro-denominated financial activities had become more rewarding vis-à-vis the dollar-denominated ones. If the macroeconomic theory had hold, the euro should have appreciated against the dollar from those decisions on. But this did not happen. The same should have happened with the decisions taken on the money supply variable. After the U.S. Government injected $2.4 trillion of relief spending into the economic system in few weeks, the Federal Reserve and its governor Jerome Powell announced a program of “unlimited” monetary stimulus. The central bank started to buy every asset it could: Treasuries, corporate bonds, junk bond ETFs and so on. The new definition for this unorthodox monetary program was “Quantitative Easing Infinity”. Or without limits. Semantics count. The possibility to do that for the Federal Reserve was granted by the fact that the new cash is nowadays produced electronically. As a consequence, the Fed’s balance sheet rose by +12.0% in a single week and that the money supply (as measured by M2 aggregate) rose at a +27.0% annualized rate since February. 

Also, the ECB decided to undertake exceptional monetary stimuli, with a €750 billion Quantitative Easing program to be carried on until the end of the year, unless the central bank decides to procrastinate it, which is quite likely. The central bank aimed to buy Eurozone countries’ sovereign bonds on secondary markets, de facto monetizing countries’ debts, even if this is explicitly forbidden by the EU Treaties. It should have bought sovereign bonds by respecting the so-called “capital key rule”, which imposes the bank strict caps on the total amount of bonds it can buy for every single state. Actually, it did not. The impression is that rules do not count when a central bank is entitled to do ‘whatever it wants’. In conclusion, the monetary stance of the Eurozone’s central bank seemed to be less expansionary than that one of the FED. The forward guidance launched by the ECB and Christine Lagarde’s declarations seemed to be more hawkish than those by Jerome Powell to investors as well. For example, Lagarde said in a press conference she excluded the possible adoption of the ‘helicopter money’ policy, and she seemed not so eager to spouse a revival of the famous Mario Draghi’s ‘whatever it takes’. Once again, we would expect, after these hawkish declarations, the euro to appreciate against the dollar, pricing in a ruder stance by the ECB with respect to that one of the FED. Instead, the euro-dollar kept almost steady. 

According to explanations provided by some forex traders, the reason why the euro-dollar exchange kept steady within the trading range 1.08-1-10, measured as dollar units to buy one euro, was the tremendous uncertainty surrounding the global economies due to the crisis. Very few analysts felt sure to depict future scenarios, and the forecasts made by the most important global forecasters differed a lot among them. Who could tell which one between the Eurozone and the US economy would have performed better or worse? Or by how much would the two GDPs, or jobless rates, have shrunk? Nobody. And since big traders knew it, they preferred not to bet on a specific market direction. They weren’t looking at the current stances of central banks but rather at the future uncertainty. 

Surely, the supporters of the old Keynesian monetary theory will try to justify the validity of their assumptions by explaining that we are facing an unprecedented crisis, which requires – as many policy-makers argued – unprecedented measures. It is just an exception. And since it is an exception, the theory must be temporarily suspended. Unfortunately for the Keynesian scholars, exceptions are becoming normality on financial markets, and it is getting more and more difficult to justify the fallacies of theories. 

What lesson can we draw from this evidence? I think that economists should take F. A. von Hayek seriously if they really want to find a key to explain why even the strongest (or supposed so) economic relations are failing in current uncertain financial times. It is useful to remind that Hayek’s definition of uncertainty is that relevant knowledge is completely dispersed and that all of the total information is divided up among a huge set of decision makers. According to the Keynesian meaning of uncertainty, instead, prices do not concentrate the knowledge so that savvy, alert decision makers (e.g. an illuminated central banker) can act on it efficiently. Hayek argues that they do. Current empirical evidence is showing that the Hayekian price discovering mechanism is at odds with the old Keynesian theoretical models. And it is the former to be true. Even in forex markets.


*Prof. Dr. Emanuele Canegrati, is an Italian economist, Senior Analyst at the London-based Forex broker BP Prime, and a Faculty Member of the Liechtenstein Academy Foundation. Canegrati also works at the Italian Parliament and the Italian Ministry for Economic Affairs and teaches as guest professor of Economics at LUISS University and La Sapienza University in Rome. He was Visiting Fellow at the London School of Economics and at the Luxembourg Income Study Office.

ECAEF is grateful for his contribution.

In Memoriam Deepak Lal (*1940 – †2020)

Deepak Lalby Kurt R. Leube*

We are all saddened by the death of Deepak Lal, one of the great minds of our time. We owe him the most seminal insights and ideas in the field of Development Economics. Born and educated in India, Deepak’s work arose and developed from a comprehensive approach to various disciplines that condition and influence one another. His scholarship was not only original and erudite, he was also prolific with a publication list of well over 12 books and numerous academic essays and sundries. Deeply suspicious of governments and politicians, Lal successfully taught at Oxford University, at the University of London and since 1991 at the University of California, Los Angeles. He was also a Senior Fellow of the Cato Institute and served as president of the Mont Pelerin Society from 2008-2010. As a scholar, teacher or colleague, Deepak came as close to the vanishing ideal of a gentleman as perhaps human frailty will ever permit. He died on April 30, 2020 in his home in London.  

To honor his legacy, we reprint here his influential paper, which he presented at the 4th ‘International Gottfried von Haberler Conference’, Vaduz (Principality of Liechtenstein) on Sept. 26, 2008.


Current Travails of Globalizing Capitalism

by Deepak Lal (USA) – James S. Coleman Professor of International Development Studies,University of California, Los Angeles

To start my talk, I would like to thank my friend Kurt Leube for the opportunity to address the 4th International Gottfried von Haberler Conference in the Principality of Liechtenstein.

I first met Gottfried von Haberler when I was a young official at the World Bank in Washington, on leave from University College, London, in the late 1970s. He and his wife became close friends, and I looked forward to our lunches at the American Enterprise Institute (which included William Fellner) as a classical liberal antidote to the daily dirigiste discourse at the World Bank. In 1983 I returned to the World Bank as the Research Administrator in Anne Krueger’s new research vice-presidency, seeking to steer the Bank’s thinking into more market oriented lines. This was the time when the 80s Third World debt crisis was in full flow. I was asked to do the first part of the 1984 World Development Report with Martin Wolf, on the global economy. We commissioned a number of background papers, one of them by Gottfried on “The slowdown of the world economy and the problem of stagflation”, which were published in a book Lal and Wolf (1986). Reading these papers and looking back at that first global financial crisis today, with the world embroiled in another crisis, the parallels are more striking than the differences.
First, both in the 1980’s and in today’s sub-prime mortgage triggered financial crisis, the crisis arose because there was a surplus of savings in a number of countries which was recycled through the international banking system, to maintain world aggregate demand. Second, highly liquid banks funneled cheap credit to borrowers who were not creditworthy by any prudential standards: the fiscally challenged and inflation prone countries of Latin America and Africa in the 1970s, the ninja (those with no income, no jobs, no assets) sub prime mortgagees of the current crisis. Third, there was a rise in commodity prices and a worsening of the terms of trade of the OECD. This posed the dilemma of stagflation for their central banks, having aided and abetted the earlier asset boom. Fourth, the imprudent banks sought bail outs from taxpayers, claiming their demise would fatally damage the world’s financial system …

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Current Travails of Globalizing Capitalism (Word Doc,  139kb)


*Kurt R. Leube is Professor Emeritus and Research Fellow at the Hoover Institution, Stanford University (USA) and Academic Director at ECAEF (European Center of Austrian Economics Foundation) in Vaduz, Liechtenstein.

Policy cures worse than the disease

GIS statement by Prince Michael of Liechtenstein

Governments first failed to respond to the COVID-19 pandemic. When they finally realized the scope of the challenge, most resorted to misguided, self-serving and often disastrous policy responses. Their push for centralization and control of economies, companies and ultimately, individuals, bodes ill for the future.

Krakow, March 25, 2020: Lock and chain on the door of one of the hundreds of closed stores in the city center. Globally, the indiscriminate closure of businesses will prove more disastrous than the pandemic itself (source: dpa)
Krakow, March 25, 2020: Lock and chain on the door of one of the hundreds of closed stores in the city center. Globally, the indiscriminate closure of businesses will prove more disastrous than the pandemic itself (source: dpa)

The disease started in Wuhan, a city in the Hubei province of China. After first ignoring the problem, the authorities in Beijing cut off the contaminated area from the rest of the country – however, they did not ban international air traffic. By the end of January, the world was facing a health problem, but that truth had still not sunk in.

The world has lost its head and gone into a panicky, large-scale economic lockdown. Coronavirus rules supreme.

The disease started in Wuhan, a city in the Hubei province of China. After first ignoring the problem, the authorities in Beijing cut off the contaminated area from the rest of the country – however, they did not ban international air traffic. By the end of January, the world was facing a health problem, but that truth had still not sunk in.

First: denial

When, on February 1, the United States began denying entry to travelers from China, the decision was loudly criticized. Many in Europe saw it as a manifestation of President Donald Trump’s anti-Chinese leanings. Tedros Adhanom Ghebreyesus, the director-general of the World Health Organization (WHO), argued that travel restrictions cause more harm than good because they hinder information flow, disrupt medical supply chains and harm the economies. Through many of his official actions, the head of the WHO has revealed his uncritical admiration for the People’s Republic of China …

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Policy cures worse than the disease


*GIS is a global intelligence service providing independent, analytical, fact-based reports from a team of experts around the world. We also provide bespoke geopolitical consultancy services to businesses to support their international investment decisions. Our clients have access to expert insights in the fields of geopolitics, economics, defense, security and energy. Our experts provide scenarios on significant geopolitical events and trends. They use their knowledge to analyze the big picture and provide valuable recommendations of what is likely to happen next, in a way which informs long-term decision-making. Our experts play active roles in top universities, think-tanks, intelligence services, business and as government advisors. They have a unique blend of backgrounds and experience to deliver the narrative and understanding of global developments. They will help you develop a complete understanding of international affairs because they identify the key players, their motivations and what really matters in a changing world. Our experts examine the challenges and opportunities in economies old and new, identify emerging politicians and analyze and appraise new threats in a fast-changing world. They offer new ideas, fresh perspectives and rigorous study.

“ESG” ist die neue Gier

Essay von Henrique Schneider*, erstveröffentlicht bei insideparadeplatz.ch, 8. April 2020

Environmental, Social and Governance heisst der neue Hype in der Finanzwelt. Was immer gemeint ist: Hauptsache Reibach. Was als aktivistischer Schrei der politischen Linke begann, entwickelte sich zu einem Reputationsproblem.

Henrique Schneider | ESG ist die neue Gier. Quelle: insideparadeplatz.ch

Jetzt haben aber die Fondsmanager an der Wall Street und am Paradeplatz das volle Potenzial von ESG erkannt: Ihre persönliche Besserstellung, ohne zur Rechenschaft gezogen zu werden. ESG ist die neue Gier.

Was ist ESG? Umwelt, Soziales und Governance (ESG) sind eine Reihe von Kriterien, um Investitionen zu prüfen. Umweltkriterien berücksichtigen, wie sorgfältig ein Investment gegenüber der Natur ist. Bei den sozialen Kriterien werden Beziehungen des Investitionsobjekts zu Menschen und Gemeinschaften untersucht. Die Governance befasst sich mit den Führungs- und Vergütungsstrukturen des Investments. Manchmal wird ESG auch als Nachhaltigkeit bezeichnet. Doch es ist unklar, in welchem Verhältnis diese zwei offenen – nicht genau umschreibbaren – Begriffe zueinanderstehen.

Darüber hinaus ist es noch immer eine offene Diskussion, ob klimabezogene Kriterien in das E passen oder ob sie etwas Zusätzliches zu ESG sind. In der Diskussion um ESG ist es wichtig, auf das besondere Verhältnis zwischen Investor und Fondmanager hinzuweisen. Das Prinzipal-Vertreter-Verhältnis ist eine Vereinbarung, bei der eine Einheit eine andere Einheit beauftragt, in ihrem Namen zu handeln.

In der Finanzwelt ist typischerweise der Investor der Auftraggeber, und die Fondsmanager sind die Agenten. Im Idealfall sollte der Agent keinen Interessenskonflikt haben, wenn er für seinen Auftraggebers handelt …

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ESG ist die neue Gier


*Henrique Schneider ist stellvertretender Direktor beim Schweizerischen Gewerbeverband und Professor of Economics an der Nordakademie Hochschule der Wirtschaft in Elmshorn, Deutschland.