Tyler Cowen writes,

I know full well that in most sensible intertemporal models the U.S. dollar is overvalued and must fall further to set right the trade balance. But these same intertemporal models don’t explain business cycles or unemployment very well…

I do know that purchasing power parity predicts long swings in exchange rates to some crude extent, and right now I’m dead set against family summer vacation in Europe. So I will accept this dare and assert that the U.S. dollar is undervalued in world currency markets.

The most painful and embarrassing memories of my youth involve either encounters with members of the opposite sex or with open economy macroeconomics.In a teenage romance movie, the young inexperienced guy wants nothing more than to be noticed by the beautiful, popular girl, but he winds up drawing attention to himself in the most awkward, traumatic way. In the Hollywood ending, she gets past it and falls in love with him.

My experiences were a lot like that.


Well, except for the Hollywood ending.

As a first-year graduate student, I went to a seminar given by third-year graduate student Jeffrey Frankel. The popular beauties in attendance probably included Andy Abel, Ben Bernanke, Olivier Blanchard, Gene Grossman, Paul Krugman (unless that was the year he took a powder in New Haven), Maury Obstfeld, and Ken Rogoff (unless that was the year he took off to become a chess grandmaster). I went because Jeff was my friend, not because I knew enough to follow the talk.

Frankel wrote down the first equation of the Dornbusch overshooting model. It said that when interest rates differ across countries, the exchange rate in the high-interest country will rise until it is expected to fall at the rate of the interest differential.

I raised my hand and asked, “But why would anyone hold a currency if they expect it to depreciate?” The answer is that people hold currency for the usual reasons (liquidity, safety, convenience, whatever). But I didn’t get it, and I wasted several minutes of Frankel’s seminar with stupid follow-ups. I’m sure that the popular beauties were not impressed.

Just as the middle-aged Arnold Kling could give the younger one some helpful advice for relating to women, the middle-aged Arnold Kling would like to be able to go back and whisper advice into his younger self’s ear. Because the overshooting model is an intellectual swindle–my younger self was just unable to put his finger on the problem.

A useful illustration is the phenomenon of a book whose cover says that the price in U.S. dollars is 22 and in Canadian dollars (Loonies) is 25, based on the out-of-date relationship between the two currencies. With the U.S. dollar now at a 10 percent discount with respect to the Loonie, in theory a Canadian who wants the book could exchange 20 Loonies for 22 dollars, walk into the Canadian bookstore, give the clerk 22 dollars, and demand the book, based on its list price. The buyer saves 5 Loonies by paying in American currency. This is goods-market arbitrage.

A couple of points. First of all, the Canadian bookstore might not take American currency. Second, whatever the list price, the Canadian bookstore could adjust the actual retail price to get rid of the arbitrage opportunity. For example, it could leave the dollar price at 22 and discount the Loonie price by 20 percent, to 20 Loonies.

If prices are adjusted instantly to eliminate goods-market arbitrage, then currency fluctuations are merely changes of units. The dollar can go up or down against the Loonie, but the relative prices of U.S. and Canadian goods are unaffected, imports and exports are unaffected, and so on. In that world, Tyler can always take a European vacation, because as the dollar declines in value, European prices are cut, too.

In reality, exchange-rate movements have real effects. So, open-economy macroeconomists wave their hands and utter the magic incantation, “sticky prices.”

But in the Dornbusch model, countries differ in terms of their inflation rates. Inflation is described mathematically as a continuous movement in prices (“Rudi Dornbusch is the master of the logarithmic derivative,” as Rogoff used to put it.) The swindle, which is present in all modern macro, is to talk about sticky prices and continuously-moving prices in the same breath.

The point of the first part of Frankel’s talk was to cast the Dornbusch model in terms of the “real” exchange rate, which is an amalgam of three variables: the exchange rate between currencies, the level of domestic prices, and the level of foreign prices. The overshooting model is one in which domestic and foreign prices move continuously but slowly, while the exchange rate jumps around, causing large shifts in relative prices.

But how do you predict where the exchange rate will jump? Tyler’s intuition is to believe in goods-market arbitrage–all the Canadians wanting to trade Loonies for dollars in order to buy cheap American goods will lead to a stronger dollar. Krugman’s intuition is to believe in portfolio balance–all the Asians and oil producers with excess dollar-denominated assets wanting to diversify their holdings will cause them to sell dollar-denominated bonds and lead to a weaker dollar.

The fundamental question in international macro is this: what do you hold constant while forcing the exchange rate to adjust? Tyler implicitly is holding nominal goods prices in the U.S. and other countries constant. Krugman implicitly is holding nominal asset prices in the U.S. and other countries constant.

The empirical evidence, following Meese and Rogoff, is that none of these models can predict where exchange rates will jump. Instead, random-walk forecasts do at least as well.

Today, I am happily married (or I’m successfully self-deceiving, if you believe Tyler’s book). But when it comes to talking about open-economy macro, I still feel awkward and embarrassed.